Rare disasters, local currency-denominated external debt and sovereign default risk

Abstract

This study investigates the impact of rare disaster shocks on sovereign default and the role of local currency-denominated external debt (LCED) in mitigating the effects of disasters. Using panel data of 52 developing countries from 2000 to 2022, we find that rare disaster shocks significantly increase sovereign default risk, while LCED can mitigate the adverse effects of rare disaster shocks. Moreover, the effect is more pronounced in lower-income countries. Mechanism analysis shows that disaster shocks increase sovereign default risk by increasing external debt service and government expenditure, while LCED weakens the mechanism of external debt service. This study provides a theoretical foundation for developing countries to increase the proportion of LCED issuance as a strategic hedge against rare disaster shocks.