Sovereign debt crises and low interest rates

Abstract

We revisit the occurrence of self-fulfilling crises in sovereign debt markets under time-varying interest rates and growth in Eaton and Gersovitz (1981)’s model. We show that, when long-term interest rates exceed growth, insolvency is solely caused by the exhaustion of the sovereign’s debt repayment capacity subject to limited commitment. Indeed, high interest rates impose discipline on market sentiments, because creditors necessarily become more optimistic about solvency when the sovereign reduces debt exposure. Creditors’ beliefs respond instead ambiguously under low interest rates fluctuating around growth. 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 as long as interest rates remain below growth. Thus, creditors’ sentiments might adjust adversely to fiscal consolidation. When the default punishment is not disproportionately severe, this mechanism sustains belief-driven debt crises even when fundamentals would otherwise ensure solvency.