Sovereign Default and International Trade

Evidence suggests that sovereign defaults disrupt international trade. As a consequence, countries that are more open have more to lose from a sovereign default and are less inclined to renege on their debt. In turn, lenders should trust more open countries and charge them with lower interest rate. As a consequence of those lower rates, the country should also borrow more debt as it gets more open. This paper formalizes this idea in a sovereign debt model á la (Eaton and Gersovitz in Rev Econ Stud 48(2):289–309, 1981), proves these theoretical relations and quantifies them in a calibrated model. This paper also provides evidence suggesting a causal relationship between trade and debt, using gravitational instrumental variables from Feyrer (Am Econ J Appl Econ 11(4):1–35, 2019) as a source for exogenous variation in trade openness. The results suggest that, when imports-to-GDP ratio increases by 1%, debt-to-GDP ratio also increases by 1%, and default risks do not increase. These last results are consistent with the quantitative results from the calibrated model.