Sovereign Debt Crises and Low Interest Rates

Abstract

We study the traditional Eaton and Gersovitz (1981)'s model of sovereign debt default under timevarying interest rates and growth. We show that, when long-term interest rates exceed growth, equilibrium is unique and liquidity crises do not occur. High interest rates impose discipline on market sentiments, as creditors necessarily become more optimistic about solvency when the sovereign reduces debt exposure. Creditors’ beliefs respond instead ambiguously under low interest rates. As long as interest rates exceed growth, debt reduction alleviates the fiscal burden. However, the sovereign also benefits from the prospect of rolling over outstanding debt while interest rates remain below growth. Thus, creditors’ sentiments might adjust adversely to fiscal consolidation. This mechanism sustains belief-driven debt crises even when fundamentals would otherwise ensure solvency.