Sovereign default, interest rates and political uncertainty in

emerging markets

Gabriel Cuadra
a,
, Horacio Sapriza
b,1
a
Direccin General de Investigacin Econmica, Banco de Mxico, Av. 5 de Mayo 18, Mxico DF, 06059, Mxico
b
Rutgers Business School, Rutgers University, Newark and New Brunswick NJ, United States
a r t i c l e i n f o a b s t r a c t
Article history:
Received 5 August 2005
Received in revised form 5 March 2008
Accepted 20 March 2008
A large body of the empirical literature shows that high turnover rates/length of tenure of
policymakers and the degree of conict within a country affects sovereign spreads, debt and
default rates. We help to rationalize such claims by including these political features in a dynamic
stochastic small open economy model of sovereign debt and default. In this way we offer a
complementary approach to the econometric analyses in the literature. Consistent with the data,
the quantitative analysis shows that politically unstable and more polarized economies
experience higher default rates and larger level and volatility of sovereign interest rate spreads.
2008 Elsevier B.V. All rights reserved.
Keywords:
Default risk
Sovereign debt
Political uncertainty
Interest rates
Small open economy
JEL classication:
F34
F41
1. Introduction
Emerging market economies usually face larger political risk and are more crisis-prone than developed countries. Many of these
economies with relatively high political risk have recently experienced episodes of sovereign default, such as Russia in 1998, Ecuador in
1999, Ukraine in 2000, and Argentina in 2001, among others. Higher sovereign interest rate spread levels and volatility are associated
with higher political risk in these countries, suggesting that political factors can help understand the behavior of their sovereign credit
risk spreads. Inthis paper, we developa dynamic stochastic small openeconomymodel toexplore theoreticallyandquantitativelysome
of the channels through which a country's political process might affect sovereign debt default incentives and interest rate spreads.
There is ample evidence of a link between political variables and sovereign risk in the empirical literature. The early work of
Citron and Nickelsburg (1987) considers one dimension of the political environment, political instability, which they proxy by the
number of changes of government over a ve-year period. They nd it a statistically signicant determinant of the probability of
default. Brewer and Rivoli (1990) nd that regime instability, as measured separately by changes in the head of government and
changes in the governing group, are statistically signicant variables in explaining the probability of sovereign default. Balkan
(1992) considers a political instability index, and nds it statistically signicant in explaining default probabilities. The political
instability index measures the level of support for the government and social unrest in the country, as proxied by the number of
government crises, riots, assassinations, general strikes, and anti-government demonstrations.
Journal of International Economics 76 (2008) 7888
We thank Per Krusell, Alan Stockman, Roberto Chang, Juan Carlos Hatchondo, participants at the 2005 Midwest Macroeconomics Meetings, a co-editor and two
anonymous referees from this journal for helpful comments. All remaining errors are our own.
Corresponding author. Tel.: +52 55 5237 2680; fax: +52 55 5237 2571.
E-mail addresses: gcuadra@banxico.org.mx (G. Cuadra), hsapriza@andromeda.rutgers.edu (H. Sapriza).
1
Tel.: +973 353 5709; fax: +973 353 1233.
0022-1996/$ see front matter 2008 Elsevier B.V. All rights reserved.
doi:10.1016/j.jinteco.2008.05.001
Contents lists available at ScienceDirect
Journal of International Economics
j our nal homepage: www. el sevi er. com/ l ocat e/ econbase
Van Rijckeghem and Weder (2004) show that politics are relevant to explain sovereign defaults on external and domestic debt
obligations. In particular, a shorter tenure of the executive corresponds to a higher probability of default. Kohlscheen (2006) also
nds that higher political turnover per se increases the likelihood of sovereign default. Some of his main results are that
reschedulings are more likely the higher the political turnover and the political opposition to the executive in the legislation, where
the latter reects the degree of polarization or disagreement among different domestic groups. In a study for Latin American
countries, Moser (2006) nds that political instability measured by cabinet reshufes involving key policymakers increases
sovereign bond spreads.
The empirical studies thus indicate that the association of foreign debt problems and political instability have been the rule
rather than the exception in emerging market economies, and suggest that political uncertainty may play a nontrivial role in
determining default incentives and the level and volatility of country interest rate spreads in developing countries. Our paper
attempts to explain how the political process of a country, in the form of political instability and polarization, can affect incentives
to borrow and repay the debt, and thus impact sovereign interest rate spreads.
Political instability and polarization in this paper are based on the modelling of the political system by Alesina and Tabellini
(1989), Persson and Svensson (1989), and Ozler and Tabellini (1991). There are two types of households in the economy and each
type is represented by a party that has a given probability of staying in ofce next period if it is in ofce today. Each party cares for
both types but assigns relatively more weight to the consumption of its own type. The model thus captures two features of the
political system: political instability, which corresponds to the probability of losing ofce, and political polarization, which is the
extent of disagreement over the consumption allocated to each group.
In our setup, political factors lead to short-sighted governments. The lower discounted value of future consumption increases
the default incentives of the government, who cannot commit to repay. This leads to higher interest rate spreads for any given
borrowing level. Thus, while the government may have a stronger incentive to borrow all other things equal, it has to pay higher
spreads for any given amount of debt compared to the case without political uncertainty.
Additionally, the incumbent party knows that being out of ofce tomorrow means that the distribution of resources among
households will differ from what it considers to be optimal. This lowers the relative cost of default compared to the case without
political instability, further increasing interest rate spreads. The disagreement on the preferred distribution of consumption among
domestic agents induces the government to borrowstrategically, tilting towards its ownpreference the future spending of the other
party in case it loses power. Therefore, both political instability and polarization tend to increase sovereign interest rate spreads.
Strategic behavior induced by political instability in innite horizon settings is also present in Amador (2003), where political
uncertainty reduces the ability of a country to save, and in Azzimonti (2006), where it leads to under-investment in infrastructure
and overspending in public goods. Like our paper, their analyses focus on Markov Perfect equilibria. However, the political
economy study by Azzimonti focuses in a closed economy setting under full reallocation of resources and does not focus on default
risk. The theoretical work by Amador does not study sovereign credit spreads either and analyzes the extreme case of full
consumption redistribution across types, which eliminates some of the strategic incentives described in our paper. Therefore, our
work also contributes to this literature by considering the more realistic trade-offs that result from the partial redistribution of
resources among groups that compete for ofce.
A relevant quantitative study of public debt that also focuses on Markov Perfect equilibria is Mendoza and Oviedo (2006).
Instead of analyzing the interaction between policymakers, their paper develops a dynamic game between the private sector and
the domestic government in a small open economy, and provides a new methodology for quantifying debt ratios consistent with
scal solvency under incomplete markets.
In order to better characterize the trade-offs that are present in our framework, we derive the Euler equation for the group in
power. This helps to see more clearly the wedges in the marginal costs and benets of asset-accumulation decisions generated by
the strategic behavior due to political instability and polarization. The probability that a policymaker that disagrees with the
incumbent party may be coming to power next period induces the latter to strategically deviate from the borrowing that it would
optimally choose under no instability. Such forward-looking behavior takes into account the expected borrowing policy by the
opposing group.
We model default using the willingness-to-pay approach introduced to the international lending literature by Eaton and
Gersovitz (1981). Arellano and Mendoza (2002) discuss how the willingness to pay approach can be used to explain emerging
market features.
2
Alfaro and Kanczuk (2005) model political factors and default in emerging markets in a model with learning but
where debt is exogenous.
Our framework is related to Arellano (inpress), who develops a quantitative model based on the willingness-to-pay approach to
study output and country spread dynamics in emerging markets. Aguiar and Gopinath (2006) study the effect of stochastic
productivity trends, which improve the empirical predictions of the model. Yue (2007) analyzes the quantitative effects of
sovereign debt renegotiation on country interest rate spreads. These models do not take into account a key feature of emerging
market economies: political risk. Therefore, our contribution to this literature is to explore theoretically and quantitatively the
effects of this variable on default incentives and country risk premium.
The paper proceeds as follows: the economic environment and the theoretical model are presented in Section 2, the
equilibrium is dened and characterized in Section 3, the quantitative implications of the model are analyzed in Sections 4 and 5
and conclusions are presented in Section 6.
2
Sturzenegger and Zettelmeyer (2007) reviews evidence from recent litigation practice and discusses whether this requires a change in the understanding of
sovereign debt markets. It concludes that the original assumptions of Eaton and Gersovitz (1981) hold surprisingly well.
79 G. Cuadra, H. Sapriza / Journal of International Economics 76 (2008) 7888
2. The model
Consider a neoclassical small open economy model with two types of domestic agents, each represented by a political party,
and foreign lenders. Each period one of the two parties is in ofce and the incumbent party remains in power with a given
probability . The only asset traded in international nancial markets is a noncontingent one-period bond that is available to the
ruling party. Debt contracts are not enforceable as the party in ofce has the option to default on them. When it defaults, the
country is temporarily cut off from credit markets and suffers an output loss. Foreign lenders charge a premium to account for the
probability of not being paid back.
Each period the country receives an endowment of goods y. The endowment is assumed to followa Markov process. Let Q(y
t +1
/ y
t
)
denote the Markov transition function. The ruling party decides on the allocation of the endowment between households, and on
foreign borrowing and repayment.
The representative agent of type i, where i =1, 2, derives utility from the consumption of a tradable good and has preferences
given by the present value of the sum of instantaneous utility functions. The period utility function is concave, strictly increasing,
twice differentiable, and follows the CRRA specication:
u C
i

C
1
i
1
2.1. The government
Political party i cares about both agents but gives a higher weight to agent i. Political party i's per period utility is given by
u C
i
1 u C
j
_ _
2:1
where (0.5, 1].
Since both parties face a similar problem, we present the optimization problem of one party, political party 1. This party faces
the following decisions: when in ofce, it must initially decide whether to default or not on the country's foreign debt, and if it does
not default it decides on the consumption allocation for each agent and on the foreign debt for next period. If it defaults, it only
decides on the allocation of the endowment between the two agents. If not in ofce, party 1 receives the resource allocations that
the other party in government optimally chooses.
The parties face intertemporal problems which are expressed in a recursive dynamic programming form where the state
variables for the incumbent party are B, y and d. B represents the amount of foreign assets, y denotes the endowment level, and d
the credit status of the country, such that d=1 if the economy has access to credit markets, and 0 if it is in autarky. The value
function of the incumbent party, who has access to credit markets and begins the period with an amount of foreign assets B and
endowment y, is denoted by V
0
(B, y). The party must decide whether to default or not by comparing the value of paying back and
remaining in the credit market, V
c
(B, y), with the value of defaulting and living temporarily in autarky, V
d
( y).
The initial default decision can be written as follows:
V
0
B; y max V
c
B; y ; V
d
y
_ _
2:2
This decision can be characterized by
D B; y
1 if V
d
y N V
c
B; y
0 othewise
_
The default policy determines a repayment set (B) dened as the set of values for output such that repayment is optimal given
an asset holding level of B, and a default set F(B) dened as the set of values of the endowment such that default is optimal given an
asset holding level of B.
C B ya : D B; y 0 f g
F B ya : D B; y 1 f g
When party 1 decides to pay, it can issue new debt and faces the following budget constraint:
C
1
C
2
y Bq B; y B
where C
i
denotes the consumption allocation for agent i made by party 1 in ofce.
A negative value of B implies that the country has foreign debt. q(B, y) is the price of the bond that pays one unit of goods next
period if the next government does not default. Whenparty 1 borrows, it sells bonds in the international credit market, and when it
lends it buys bonds from foreign creditors. When the incumbent party borrows, the price of the bond reects the possibility that
next period's ruling party defaults, so this price should depend on B and on y (since today's output shock affects the probability
80 G. Cuadra, H. Sapriza / Journal of International Economics 76 (2008) 7888
distribution of next period shock) because the incentives to default depend on both factors. Therefore, the value of paying back,
V
c
(B, y), and the government's problem when it participates in international credit markets can be expressed as:
max
C
1
;C
2
;B
u C
1
1 u C
2
N
N
y
V
0
B; y 1

V
0
B; y
_
Q y=y
_
_ _
s:t:
2:3
C
1
C
2
y Bq B; y B
The incumbent policymaker decides on foreign debt issuance and on the allocation of the country's resources between agents.
Since the country did not default, it will have access to the credit market next period. Party 1 remains in ofce with probability , in
which case it will face the same problemnext period. On the other hand, party 1 will be out of power with probability 1, inwhich
case party 2 will be in ofce. V

0
represents the value for party 1 whenparty 2 is inofce andthe country has access to credit markets.
When the incumbent party decides to default, the country suffers an output loss and it is temporarily excluded from nancial
markets. Then, the value of defaulting, V
d
( y), and the problem for party 1 when the country is in autarky is as follows:
max
C
d
1
;C
d
2
u C
d
1
_ _
1 u C
d
2
_ _
N
N

y
V
0
0; y 1

V
0
0; y
_
Q y=y
1
y
V
d
y 1

V
d
y
_ _
Q y=y
_ _
_

_
_

_
s:t:
2:4
y
d
C
d
1
C
d
2
The ruling party allocates the autarky endowment y
d
between agents. The following period the country may regain access
to external markets with probability . When the economy returns to credit markets, it does so with no debt, B=0. With probability
1, the country will remain in autarky. In addition, the ruling party will continue in ofce with probability and it will be
replaced by the other party with probability 1.
Thus, with a probability , the country will return to capital markets and party 1 will remain in ofce. In such a case, the
value for party 1 will be V
0
. With a probability (1), the country will come back to external markets, party 2 will replace party 1
and the value for party 1 will be V

0
. On the other hand, with a probability (1), the country will stay in autarky and party 1 will
remain in power. In such a case, the continuation value for party 1 will be V
d
. With a probability (1)(1), the country will
remain excluded from external markets, party 2 will take over and the continuation value for party 1 will be V

d
.
When party 2 is in power, it faces a similar problem. Let D(B, y) represent the default decision made by party 2. Thus, the value
for party 1 when party 2 has the option to default can be expressed as follows:

V
0
B; y

V
c
B; y if D B; y 0

V
d
B; y if D B; y 1
_
_
_
where V

c
(B, y) represents the value for party 1 when party 2 is in ofce and it decides to repay the outstanding country's foreign
debt, and V

d
(B, y) represents the value for party 1 when party 2 is in power and it decides to default.
If party 2 decides to honor the country's foreign debt, it will be able to borrowfromabroad and allocate the country's resources
between the agents. C
i

denotes the consumption allocation for agent i made by party 2 in ofce, and B(B, y), its borrowing
decision. Thus, V

c
can be written as

V
c
B; y u C

1
_ _
1 u C

2
_ _
N
N
y
1 V
0
B; y

V
0
B; y
_
Q y=y
_ _
2:6
When party 2 defaults, it only decides on the allocation of the country's endowment between households. C
1
d
and C
2
d

denote
the consumption allocation for agents 1 and 2, made by party 2 in ofce when the country is in autarky. The expression for the
utility of party 1 when it is not in ofce and the country is in autarky, V

d
, is

V
d
y u C

1
_ _
1 u C
d
2
_ _
N
N

y
1 V
0
0; y

V
0
0; y
_ _
Q y=y
1
y
1 V
d
y

V
d
y
_ _
Q y=y
_

_
_

_
2:7
The problem for party 2 is analogous to the one for party 1 and the following notation is used:
J
0
(B, y) is the value function of party 2 when it is in ofce, it has access to credit markets, and it begins the period with an
amount of foreign assets B and endowment y, J
c
(B, y) represents the utility from repaying debt for party 2 when it is in ofce,
and J
d
(y) represents the utility of not repaying for party 2.
81 G. Cuadra, H. Sapriza / Journal of International Economics 76 (2008) 7888
J

0
(B, y) represents the utility for party 2 when party 1 is in ofce, the country has access to international credit markets, and
party 1 has the option to default, J

c
(B, y) represents the utility for party 2 when party 1 is in ofce and decided to pay the debt
and J

d
(y) is the utility for party 2 when party 1 is in ofce and decided to default.
C
1

, C
2

are the optimal consumption and saving choices made by party 2 when the country is in nancial markets, D (B, y)
is the optimal default decision, and C
1
d
, C
2
d
are the optimal consumption choices made by party 2 when the country is in
autarky.
2.2. Foreign lenders
Foreign lenders are risk neutral. They can borrow or lend resources at risk free rate r
f
in an international credit market and
provide credit to the small open economy in the form of noncontingent one-period bonds.
They have perfect information regarding the economy's endowment and political processes, and they choose loans B to
maximize expected prots. Then, when party 1 is in ofce, lenders maximize the following expression:
qB
1 B; y
1 r
f
B
1 1 B; y
1 r
f
B
and if party 2 is in ofce, lenders maximize
qB
1 B; y
1 r
f
B
1 1 B; y
1 r
f
B
where q and B are the bond price and the amount of assets issued by the government if party 1 is the incumbent policymaker, q
and B are the bond price and the amount of assets if party 2 is in ofce. and are the endogenous default probabilities for
party 1 and party 2, respectively. is the probability of staying in ofce for any incumbent party.
Perfect competition in the credit market implies that the zero-expected prot condition for the foreign creditor must be
satised. The bond price if party 1 or 2 is in ofce today is respectively:
q B; y
1 B; y
1 r
f

1 1 B; y
1 r
f
q B; y
1 B; y
1 r
f

1 1 B; y
1 r
f
3. Equilibrium
The paper analyzes Markov Perfect Equilibria, i.e. subgame perfect equilibria that use Markov strategies. Parties are assumed to
play only stationary Markov strategies: their decisions are only a function of the payoff relevant state variables. There is no
reputation building under this assumption, so whatever occurred in the past does not affect the politicians current behavior.
Krusell and Smith (2003), Krusell and Rios-Rull (2002), and Hassler et al. (2005) argue that there could be more than one Markov
equilibriumin innite horizon economies. These Markov equilibria that do not correspond to limits of nite horizon equilibria, rely
on discontinuous strategies (Klein et al., 2004). In order to avoid these issues, we focus on the Markov equilibriumwith continuous
strategies that arises as the limit of the nite-horizon economy.
Denition 3.1. A stationary Markov strategy for parties 1 and 2 is a prole of consumption C
i
(B, y), C
i
d
(y), C
i

(B, y), C
i

d
(y) for i =1,
2, default functions D(B, y), D(B, y), and asset functions B(B, y), B (B, y) such that X={D(B, y), B(B, y), C
i
(B, y), C
i
d
(y)} for party 1,
and X={D(B, y), B(B, y), C
i

(B, y), C
i

d
(y)} for party 2.
Denition 3.2. A recursive equilibrium for this small open economy is characterized by
i. a set of value functions V
0
, V
c
, V
d
, V

0
, V

c
, V

d
for party 1 and J
0
, J
c
, J
d
, J

0
, J

c
, J

d
for party 2,
ii. a set of policies for consumption C
i
(B, y), C
i
d
(y), i =1,2, C
i

(B, y), C
i

d
(y) i =1,2, default policies D(B, y), D(B, y), and asset
holdings B(B, y), B(B, y) for parties 1 and 2, respectively,
iii. a set of default probability functions: (B, y) and (B, y) for parties 1 and 2, respectively, and a set of bond price functions:
q(B, y) and q(B, y) for parties 1 and 2.
such that
1. Given the bond price function q(B, y) and party 2 strategies, party 1 value functions V
0
, V
c
, V
d
, V

0
, V

c
, V

d
and default policy
D(B, y) solve problem (2.2), and party 1 policies for asset holdings B(B, y) and for consumption C
i
(B, y), i =1, 2 solve
problem (2.3), C
i
d
(y), i =1, 2 solves problem (2.4), and analogously, for party 2, for value functions J
0
, J
c
, J
d
, J

0
, J

c
, J

d
and
policies D(B, y), B(B, y), C
i

(B, y), C
i

d
(y), i =1,2, given the bond price function q(B, y) and party 1 strategies.
2. Given (B, y) and (B, y), the bond price functions q(B, y) and q(B, y) are such that all agents in the small open economy
are optimizing and international lenders obtain zero-expected prots.
82 G. Cuadra, H. Sapriza / Journal of International Economics 76 (2008) 7888
We focus on a symmetric equilibrium: both parties play the same strategies, so the problemfaced by the parties is the same. For
any given state of the economy, the party in ofce faces the same problem, regardless of the party.
Denition 3.3. A Symmetric Markov Equilibrium (SME) is a set of policies for consumption, default and asset holdings (X
S
) for each
party such that for any B, y, d and any other feasible values X, V
0
(B, y/X
s
, X
s
) V
0
(B, y/X, X
s
) for party 1, and J
0
(B, y/X
s
, X
s
)J
0
(B, y/X, X
s
)
for party 2.
In the SME, the value generated by following X
s
, X
s
is equal or larger than the one generated by any other feasible allocation X,
while the given party is in power and when the other party follows X
s
.
In the symmetric equilibrium in those states where party 1 defaults, party 2 will also default: default and repayment sets are
equal for both parties. When parties do not default, they choose the same amount of foreign assets. Therefore, for any given state
(B, y) both parties make the same default decision D
s
() and asset holding decision B
s
(), so the unique default probability function
is denoted as
s
(B, y) and the bond price collapses to
q
s
B; y
1
s
B; y
1 r
f
where B B
s
B; y
The symmetric equilibriumbond price q
s
(B, y) reects the probability of default of the incumbent party,
s
(B, s), which results
from

s
B; y
yaFs B
Q y=y 3:1
Proposition 1. If parties play Markov strategies and party i preferences are given by (2.1), then party i allocates consumption between
the agents according to the following condition:
u
c
C
i
1 u
c
C
j
_ _
3:2
In a Markov equilibrium, consumption allocation decisions do not affect tomorrow's state. If the ruling party does not default
and borrows B from abroad, it allocates the available resources between the agents. The consumption decision will not affect the
state next period since the government already paid back the debt and the country will be in good credit standing, the incumbent
party already borrowed B from abroad, and the outstanding foreign debt for next period will be B. Finally, the endowment level
for next period y does not depend on the decisions made by the ruling party. Therefore, party i sets the consumption allocations to
maximize its per-period utility, which implies allocating consumption according to (3.2).
3.1. Further characterization
The equilibriumbehavior in this economy can be further characterized by analyzing the trade-offs faced by an incumbent party
when deciding on the accumulation of assets. In order to analyze the equilibriumin terms of rst order conditions, we followKlein
et al. (2004), Krusell and Smith (2003), Krusell and Rios-Rull (2002), Hassler et al. (2005), and Azzimonti (2006), and assume that
savings and consumption rules are differentiable. We can then derive the Euler Equation for the party in ofce.
3
This equation is
also known in the literature as the Generalized Euler Equation (GEE). In our setting, the expression for the GEE of party 1 is
u
c
C
1
q B; y
Aq B; y
AB
B
_ _

yaF B
u
c
C
1
Q y=y N
N
yaF B
1 u
c
C

_ _ AC

AB
1 u
c
C

_ _
AC

AB
_ _
Q y=y N
N
yaF B

1 u
c
C

_ _
q BW; y
Aq BW; y
ABW
BW
_ _
:::
N 21
yF B
1 u
c
C

_ _
Q y=y
_
_
_
_
Q y=y
ABW
AB
3:3
where C
1
, C
2
are the optimal consumption policies for types 1 and 2, respectively, determined by party 1 when it is in ofce, and C
1

,
C
2

are the optimal consumption policies for the respective types determined by party 2. The specic functional form of the utility
function was not used in the derivation of the GEE. Therefore, this equation describes the optimal behavior of an incumbent party
in a political equilibrium under default risk and output uncertainty, and helps to describe the marginal costs and benets of
incurring in additional borrowing within such setting.
If the party in ofce today would remain in power indenitely, the equation that describes the optimal behavior of the ruling
party would be
u
c
C
1
q B; y
Aq B; y
AB
B
_ _

yaF B
u
c
C
1
Q y=y
3
The detailed derivation of the GEE is available from the authors upon request.
83 G. Cuadra, H. Sapriza / Journal of International Economics 76 (2008) 7888
which is the expression derived when there is only one party (see, for instance, Arellano, in press and Aguiar and Gopinath, 2006).
In the model with political uncertainty, there is a positive probability that the incumbent party may not be in ofce next period.
The disagreement on the preferred consumption weights between parties gives way to a dynamic game between forward-looking
agents that induces the government to borrow strategically taking into account the other party's spending preferences and the
chance of losing power. Therefore, the presence of political uncertainty introduces a wedge in the rst order condition of the party
in ofce compared to an economy without political features. Such difference in the rst order condition with and without political
uncertainty is summarized by three effects.
The rst effect is the discount or impatience effect (rst termon the right hand side of (3.3)). Since there is a probability that the
incumbent party will not remain in power next period, the discounted marginal utility gain next period from a marginal increase
today in the foreign asset position of the incumbent party is discounted more heavily compared to the marginal gain in the case
without uncertainty. This tilt toward current consumption with respect to the case without political uncertainty entices further
borrowing precisely to increase today's consumption relative to tomorrow's, and thus induces higher credit spreads.
A second effect, which is captured in the second line of (3.3), is the polarization or disagreement effect. The incumbent party
knows that being out of ofce tomorrow means that the distribution of resources will not follow its preferences. Indeed, with
probability 1 optimal consumption allocation will be made by the other party in the form of C
1

and C
2

. In such case, higher

savings today will raise future optimal consumption by
AC
1

AB
and
AC
2

AB
; which will only increase the current incumbent's utility
tomorrow by u
c
C
1

_ _
AC
1

AB
1 u
c
C
2

_ _
AC
2

AB
because tomorrow's consumption allocation is done according to the other party's
preferences. If party 1 increases its savings, it will leave more resources for party 2 to spend next period in a way that party 1 does
not agree with: from the perspective of party 1, party 2 will assign relatively too little resources to type 1 households compared to
type 2. Thus, it is convenient for policymaker 1 to reallocate resources from tomorrow to the present because although its utility
decreases in the future, it increases more today since any resources available for current consumption are allocated according to
the incumbent's preferences.
The third effect also has strategic implications and follows from the last line of Eq. (3.3). It shows that the level of borrowing of
the incumbent party not only affects future consumption spending but also future borrowing of the other party, in the case it takes
over next period,
ABW
AB
. If a lower value of reduces the value of the third line of the GEE, then its effect would be to increase
borrowing because when the value of this expression falls, in order to keep the equality between the right and left hand sides of the
equation, it is necessary to reduce the LHS, i.e. u
c
C
1
q B; y
Aq B; y
AB
B
_ _
: This is obtained by raising C
1
, for which party 1 would
borrow more. On the other hand, if reducing increases the value of the third line, the opposite incentives are in place.
The above effects tend to increase the relative importance of current consumption. They make the government be willing to
take loans at higher interest rates in order to reallocate resources from the future to the current period, and correspond to a
movement along the bond price schedule. At the same time, higher political uncertainty makes the government more prone to
default. Thus, it starts paying a risk premium at lower levels of foreign debt, which means that the government would pay higher
interest rates for any given amount of borrowing compared to a no-political uncertainty situation. This can be described as a shift of
the bond price schedule back toward the origin that also increases sovereign spreads. Therefore, regarding the borrowing amount
in equilibrium, the movement along the bond price schedule tends to increase it, but the shift back reduces it. The overall effect on
the equilibrium borrowing will thus depend on which driving force dominates.
4. Quantitative analysis
The model is solved numerically and the parameters are based on existing data and empirical work on emerging markets.
Argentina is used as a benchmark because a long time series on country interest rates is available. The data are seasonally-adjusted,
quarterly real series obtained from the Argentinian Ministry of Economy and Production (MECON). The business cycle statistics
include quarterly data available up to the last quarter of 2001 in which the country defaulted. The interest rates for Argentina are
obtained from Neumeyer and Perri (2005) and cover the period from the third quarter of 1983 to 2001. Interest rate spreads
correspond to the difference between the interest rate for Argentina and the yield of the 5 year U.S. treasury bond. Output and
consumption are in logs and ltered with a linear trend. They span the period from1980 to 2001. The trade balance is presented as
a percentage of GDP. Regarding the Argentinian default rate, Bein and Calomiris (2001) report two episodes of sovereign default in
Table 1
Parameter values
Political risk parameter 0.90
Disagreement parameter 0.62
Discount factor 0.953
Risk aversion 2
Re-entry probability 0.282
U.S. real interest rate r
f
0.017
Default penalty 0.969
Endowment process
y
0.945

y
0.025
84 G. Cuadra, H. Sapriza / Journal of International Economics 76 (2008) 7888
the last two hundred years. The country defaulted one more time in 2001. Thus, it has defaulted three times in approximately one
hundred years, implying an annual default rate of 3%. The rst column of Table 2 shows the statistics for the Argentinian data.
The calibration involved choosing the functional form of the utility function and the values of the parameters. The household
utility function follows the CRRA specication. Thus, the party i per-period utility is:

C
1
i
1
_ _
1
C
1
j
1
_ _
where is the weight assigned by party i to the consumption of household i.
The endowment y
t
for the small open economy follows an AR(1) process
y
t
y
t1

t
where (1, 1),
t
N(0,
2
).
The endowment in autarky y
d
is specied following Arellano (in press). Thus, it is assumed that default entails some direct
output cost of the following form:
y
d

/E y if y N /E y
y if y V /E y
_
In order to analyze the effect of political variables on the magnitude and volatility of interests rate spreads, the default
frequency and debt/gdp levels, our starting point is Arellano (in press) with risk neutral pricing. In our paper, this corresponds to
the case where there is one party always in power and it values only the consumption of one type of agent. The political risk
parameterization also includes the probability of staying in ofce and the degree of polarization. The parameters for the model are
shown in Table 1.
To analyze the effects of political uncertainty on incentives to default and sovereign interest rate spreads, different values are
considered for the continuation probability, with =0.9 as the benchmark. We can interpret as the likelihood that the incumbent
policymaker will remain in ofce. Its value is consistent with the average turnover ratio for governments in Argentina for the
period 19822003.
4
Additionally, in order to analyze the effects of polarization on the level and volatility of sovereign interest rate
spreads, we consider different values for the disagreement parameter . The =0.62 benchmark value allows the model to generate
a trade balance volatility close to the one for Argentina.
5
5. Results
This section analyzes the simulation results and the statistical properties of the model economy. Table 2 shows the business
cycles moments for the Argentinian data, for Arellano (in press) and for the models with political uncertainty. We simulate the
model and nd 10,000 default episodes, thenwe extract the 74 observations before the default event and report the mean statistics
from these 10,000 samples. The simulated series are logged and ltered as the data.
The third column of Table 2 shows the results for the benchmark political economy model. The model captures several features
of emerging market economies. First, spreads are countercyclical: the negative correlation of output with spreads is consistent
4
From the third quarter of 1982 to the rst quarter of 2003, eight presidents take over and leave power in Argentina. The value of of 0.9 is consistent with this
fact, since it implies that governments stay in ofce approximately 2.5 years on average.
5
For instance, for a given increase in output, the higher the disagreement the larger the borrowing and the larger the increment in consumption, which is
reected in the trade balance.
Table 2
Argentinian Arellano Political uncertainty model
Data (2007) Benchmark Beta 0.969
Mean bond spreads 10.25 3.58 5.29 3.28
Bond spreads S.D. 5.58 6.36 7.59 6.12
C S.D./GDP S.D. 1.10 1.09 1.16 1.09
TB S.D. 1.75 1.50 1.79 1.44
Corr. (Spread-GDP) 0.88 0.29 0.31 0.27
Corr. (C-GDP) 0.98 0.97 0.95 0.97
Corr. (TB-GDP) 0.64 0.25 0.26 0.21
Corr. (C-Spread) 0.89 0.36 0.39 0.35
Corr. (TB-Spread) 0.70 0.43 0.35 0.31
Mean debt (% GDP) 48.79 5.95 6.87 6.01
Default rate (%) 3.00 3.00 4.80 3.01
85 G. Cuadra, H. Sapriza / Journal of International Economics 76 (2008) 7888
with the data for emerging economies, though the magnitude is lower. Second, aggregate consumption is more volatile than
output and highly correlated with it. The model also accounts for the negative correlation between the trade balance and output as
observed in the data. The countercyclical nature of both the trade balance and spreads implies that in good times there is more
borrowing at lower interest rates.
Fig. 1 plots the discount bond price schedule as a function of assets for two values of the shock. As the debt increases, the bond
price falls due to the stronger incentives to default and, given a debt level, the lower the output realization the lower will be the
price because the incentives to default are larger in bad times.
Regarding the interest rate spread levels, while in the absence of political risk the average spread is about 3.5%, in the
benchmark political uncertainty model the rate increases to 5.29%. Thus, it is closer to the value observed in the data. Given the no
arbitrage condition for foreign creditors, this result is obtained at the cost of increasing the default rate.
The fourth column of Table 2 shows the results for the model with political uncertainty and a discount factor equal to 0.969.
With this value the model matches the default rate of 3%.
One problemof quantitative models of sovereign debt is that they require a lowvalue of the discount factor to match the default
rate observed in data, for instance Arellano (in press) uses a value of 0.953, which is relatively low for quarterly data.
In this sense, our work introduces a more disciplined way to explain the default rate, an thus the average interest rate spread in
the model. The inclusion of political variables induces the policymakers to be willing to borrowat higher interest rates, due to the
impatience and disagreement effects. Thus, the modeling of political risk enables the model to generate higher values for interest
rate spread levels and volatility. An alternative reading, shown in the fourth column of Table 2, is that considering the benchmark
political parameters the model can match the default rate found in the data with a more reasonable value of the discount factor.
Such results highlight a certain level of substitutability between and the values of and , which are more tangible and
measurable since they correspond to the presence of political risk in a country in the form of political turnover and polarization.
Table 3
Sensitivity analysis
S.D. Average Correlation Default Debt/GDP
Spread Spread (GDP-Spread) Rate
Political risk
0.95 5.28 2.23 0.21 2.06 5.40
0.90 6.12 3.28 0.27 3.01 6.01
0.85 6.46 4.17 0.29 3.81 6.47
Disagreement
0.55 5.31 2.55 0.24 2.35 5.47
0.62 6.12 3.28 0.27 3.01 6.01
0.70 6.30 3.96 0.27 3.62 6.35
Fig. 1. Bond price.
86 G. Cuadra, H. Sapriza / Journal of International Economics 76 (2008) 7888
In order to assess the impact of political uncertainty and polarization on default incentives and country spreads, different values
of and were considered. Table 3 illustrates the sensitivity of different macroeconomic variables to changes in these dimensions
of political risk.
6
The political process implies that anincumbent party may be out of ofce next period. The stochastic alternationof policymakers
in power induces a short-sighted behavior that affects the intertemporal trade-offs of the policymakers, inducing sovereigns to
borrowat higher premia. Additionally, there is a disagreement effect given by the degree of polarization: the party in power knows
that being out of ofce next period implies that the allocation of resources will not follow its preferences. Thus, it has additional
incentives to reallocate resources from the following period to the present. These impatience and disagreement effects imply that
governments are willing to borrow resources at higher interest rate spreads, which are associated with larger default risk premia.
In the economy with low levels of political risk and polarization, sovereign interest rate spreads are lower. As the borrowing
increases, the bond price is reduced and the government has to pay a higher interest rate. The incumbent party takes into account
this effect and borrows an amount that implies a lower risk premium compared to the case of economies with either lower values
of or higher values of . On the other hand, in economies with higher political risk and polarization the incumbent party is willing
to borrow at higher interest rates because of the impatience and disagreement effects.
For instance, when the probability of staying in power decreases from 0.95 to 0.85 the spread level increments from 2.23% to
4.17%. A similar relationship is observed between spreads and the polarization parameter, . Given the no arbitrage condition of
foreign lenders, higher spreads are associated with higher default rates.
The stronger incentives for policymakers to borrow at higher interest rates also imply higher spread volatilities and debt levels.
When we reduce the value of from 0.95 to 0.85, the spread volatility increases from 5.28% to 6.46%, and the debt/output ratio
increases from 5.40% to 6.47%. Similar results are obtained when we increase the value of . Finally, introducing political variables
appears to move the debt/gdp level in the direction of the data, although it still falls signicantly short. A paper in this quantitative
default literature that discusses relevant economic mechanisms that may increase theborrowing/gdpratiois Mendoza andYue(2007).
In order to further assess the quantitative predictions of the model, we examine the data of a set of developing countries and
compare comovements found in these data with those predicted by the model.
7
Fig. 2 shows the relationship between the EMBI
spread and political risk, which is measured as an incumbent's probability of remaining in power.
8
As the gure illustrates,
countries with higher political risk, i.e. lower values of , tend to pay higher spreads: the correlation is 0.63, which is statistically
signicant and has a standard error of 0.20. Additionally, we also analyze the relationship betweenpolitical risk and the volatility of
the cyclical component of the EMBI spread and we nd a correlation of 0.70, which is also statistically signicant and has a
standard error of 0.18. Thus, the data suggests that the higher the level of political risk, the higher the spread volatility.
In order to compare the predictions of the model with this empirical evidence, we simulated the model for each country and
calibrated the parameters of the endowment process to match the cyclical behavior of output for each country. Fig. 2 shows the
results fromthe simulations: although the spread levels are still lower than those in the data, the model is able to capture both the
6
A value of 0.969 for the discount factor was used in the sensitivity analysis of Table 3.
7
Given the availability of data, we include the following emerging market countries: Argentina, Brazil, Bulgaria, Chile, Colombia, Ecuador, Philippines, Morocco,
Mexico, Nigeria, Panama, Peru, Poland, Russia, South Africa, Turkey, and Venezuela.
8
For computing the value of , we use information fromwww.worldstatesmen.org and we use the same procedure used for computing the value for Argentina.
Fig. 2. Political risk-spread.
87 G. Cuadra, H. Sapriza / Journal of International Economics 76 (2008) 7888
negative correlation between and spreads, where a value of 0.84 is obtained, and with spread volatility, where it generates a
correlation of 0.81.
6. Conclusions
A body of empirical literature points out that high turnover rates/length of tenure of policymakers and the degree of conict
within a country affect sovereign debt, country spreads and default rates. Countries that are subject to larger political uncertainty
and stronger domestic disagreement tend to be charged a higher default risk premium in international credit markets. We help to
rationalize these ndings by developing a model of a small open economy where two political parties stochastically alternate in
ofce and default is an equilibrium outcome. Thus, we analyze the impact of political instability and polarization on default
incentives and country interest rate spreads in emerging markets.
We seek to explicitly analyze different channels through which political variables can affect the borrowing incentives and credit
spreads paid by emerging economies in a fully dynamic equilibrium setting. To better characterize the trade-offs faced by a
policymaker in the economy and thus assess the impact of political factors on governments' incentives to borrow and default, we
derive a generalized Euler equation for the incumbent policymaker. By assessing the impact of both polarization and instability on
default and country risk premia, we provide a complementary approach to the econometric analyses in the literature.
The presence of political risk also improves some of the results in the literature of quantitative models of sovereign debt and
default, allowing these models to bring the level of country interest rate spreads closer to the data using more standard parameters
values. However, the model generates too low debt/gdp levels and a very tight link between default risk and interest rate spreads.
A recent related paper that shows promise in improving such statistics is D'Erasmo (2007) who considers a model of sovereign
default and debt renegotiation where a government transits through different political states that cannot be directly observed by
lenders. His results suggest a mechanism that can generate higher debt/gdp ratios at observed default rates. His framework thus
appear to be a promising avenue for further research in the area of sovereign default and political economy.
The link between political variables and default risk suggests that efforts to support stable political environments, including
attempts to reconcile radically opposing strategies on resource allocation between groups that struggle for power, could contribute
to improve a country's borrowing incentives and thus foster stability of international credit markets. This would in turn reduce the
credit spreads paid by sovereign borrowers.
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