Sovereign risk: Sanctions and Reputation
The risk that a sovereign will not honor its obligations with foreign investors is mitigated by two factors: the threat of sanction and the loss of reputation. Direct sanctions may involve significant costs for defaulting countries. For example, sanctions could take the form of intercepting payments that the sovereign might make to exporters or payments it might receive from importers. Potential exporters to the country might then be less willing to supply the debtor country, knowing that their compensation might be intercepted. Generally, however, the net gain to creditors fromsanctionswill be less than the cost to the debtor. In theoretical models of sovereign borrowing with sanctions, the optimal amount of borrowing is constrained by the sanction cost: the parties to the debt contract write an incentive-compatible contract that never calls on the sovereign to make a payment to foreign creditors in excess of the sanction cost. This incentive-compatibility constraint leads to less lending than would be the case in a world where no country ever defaulted. An implication of this line of theorizing is that stronger, credible sanctions would allow sovereigns to increase the amount of their borrowing.
Reputation considerations provide another motive for sovereigns to honor obligations with foreign investors. A sovereignmight choose to repay in order tomaintain continued access to international capital markets on favorable terms.This ideawas articulated in work that showed formally the conditions under which countries repay debts in order to preserve a reputation for repayment (Eaton and Gersovitz 1981). Subsequent work questioned whether reputational considerations alone were enough to sustain international lending in the absence of effective sanctions (Bulow and Rogoff 1989). If defaulting countries are able to earn a market return on their savings abroad they could, in theory, borrow, invest the funds abroad, default on the loan, and use the proceeds of their investments abroad to finance domestic investment opportunities in perpetuity.
Reputation models of international lending were revived by Cole and Kehoe (1997), who countered that reputation alone may support international lending if reputational spillovers are important enough. They argue that sovereigns participate in many different relationships. If they renege in one of those relationships, the damage may have adverse consequences for other relationships. If the spillovers are large enough and last long enough, then reputation considerations alone cannot support international borrowing and lending, without resort to the threat of direct sanctions. In general, though, if countrieswithpoor credit histories are able toborrow abroad without fear of their assets being confiscated, the threat of reputation loss becomes less of a factor in deterring default.