Study on Timing of Sovereign Defaults Over Electoral Terms

Description
Sovereignty is the quality of having independent authority over a geographic area, such as a territory. It can be found in a power to rule and make laws that rests on a political fact for which no pure legal definition can be provided. In theoretical terms, the idea of "sovereignty", historically, from Socrates to Thomas Hobbes, has always necessitated a moral imperative on the entity exercising it.

Study on Timing of Sovereign Defaults Over
Electoral Terms

Nathan Foley-Fisher
†


March 2012




Abstract

I construct a database that maps the timing of sovereign default decisions into elected
politicians' terms of ofce, that provides an empirical means of investigating political economy theories of
sovereign default. I find no robust patterns in the timing of default decisions over terms of ofce. I also
find no evidence in support of the political reputation theory of sovereign debt repayment. Finally,
there is some tentative evidence that elected leaders who default are also those more likely to be re-
elected. Motivated by anecdotal evidence, I use a stylised model of political leaders with career
concerns to demonstrate how this can occur when politicians care about re-election.

Keywords: Sovereign default, electoral cycles, career concerns
JEL Classification: F34, H63

























Introduction
It has been shown both theoretically and empirically that macroeconomic policy deci-
sions are in?uenced by cycles of election and re-election, and that the timing of specific policies
can re?ect concerns about impending or receding elections (Rogof and Sibert, 1988; Alesina et
al., 1997). It follows naturally that the decision to enter into sovereign default may be afected by
political economy considerations, and there is a good body of supporting theoretical research
(Amador, 2004; Tomz, 2007; Cuadra and Sapriza, 2008). However, as noted by Panizza et al.
(2009), comparatively little empirical analysis of the political economy of sovereign default has
been conducted. In this paper, using a specially- constructed database that maps the timing of
sovereign default decisions into democratic governments' electoral cycles, I empirically
investigate two broad political economy theo- ries of sovereign default: (i) that some types of
government treat the decision to default diferently; and (ii) that a reduced likelihood of re-election
following a default is a direct cost that helps ensure sovereign debts are repaid.
I focus on three key results: first, that there are no significant patterns in the timing of
default over elected politicians' terms in ofce. This suggests that elected politicians do not take
default decisions strategically, in a game-theoretic sense, in order to improve their chances of re-
election. For an elected leader, potential strategies may include defaulting in the run-up to an
election as a signal of strong leadership or, if default is detrimental to the output of an economy,
defaulting at a time when their political mandate is strongest - most usually in the immediate
aftermath of an election. It is not therefore possible, a priori, to say with certainty what empirical
patterns would be expected in default decisions over elected terms of ofce.
Second, I show there is no evidence that the defaults occurring in early periods of political
tenure are correlated with good times, defined according to a variety of difer- ent measures. This
finding contradicts a key implication of theories that some types of government treat the decision
to default diferently (Eaton, 1996; Tomz, 2007). In those models, governments are typically one
of two types: 'good' governments only default in poor economic circumstances (bad times), while
'bad' governments are willing to default irrespective of economic circumstances. The choice of
government is typically modeled as a reduced form stochastic process over types which generates
uncertainty about future types, but lenders are nevertheless willing to extend sovereign credit,
while charging a premium, because they get repaid with some probability. The empirical
corollary is that all sovereign defaults in good times are also those that occur early in a term of
ofce, because those decisions must have been taken by bad governments which default in all


2
times.
Third, I demonstrate a weakly positive relationship between elected leaders who de- fault and
those who are re-elected. This finding builds on Borensztein and Panizza (2010) but draws
distinction from the default decisions of unelected leadership and controls for leaders that cannot
be re-elected for institutional reasons, for example term limits. As in previous empirical work, I
cannot establish the causal relationship between default and re-election. Instead I use anecdotal
evidence to motivate a model-based explanation where political leaders inherit a debt burden, that
may or may not have been at the social welfare maximising level, and must decide whether or not
to default.
The stylised model draws from the theoretical literature of experts with career con- cerns.
1
I
explicitly distinguish two types of politician: those who have as much information as the average
voter and are unaware which actions deliver the aggregate social optimum (incompetent); and
those that perfectly know how much debt they should contract and when they should default
(competent). Since both types know which they are in advance, the first best outcome is that only
competent politicians would be elected. However, voters neither observe the optimal default
decision, nor the optimal debt contracting de- cision. This asymmetric information allows the
incompetent politician to pretend to be competent, in the hope of being re-elected, but ex-post
utility allows voters to update a prior and learn about the competence of the politician over time.
I show the existence of a perfect Bayesian equilibrium where an incompetent politician
pursues a strategy of pretending to be competent: he chooses a level of debt randomly. He is re-
elected with positive probability because he sometimes makes the correct decision. At the heart
of the model is the assumption that a competent agent knows the socially optimal action to take.
By acting in the social interest, the competent politician assures that he will be re-elected. An
incompetent politician who doesn't know the state of the world, but wishes to be re-elected, is
forced to choose a randomisation strategy and hope that he is mistaken for a competent agent.
However, since sovereign default is rarely the socially optimal action in the model, the
incompetent politician does not default as often as a competent politician. Therefore the decision
to default reveals political competence and causes voters to re-elect the politician.
In preview, the paper begins by introducing the data in section 2.1; and presents the three
key empirical results in sections 2.2-2.4. These are followed by some anecdotes on the political
economy of default episodes in section 2.5 that motivate the model detailed

1
For example, Holmstrom and Ricart i Costa (1986); Scharfstein and Stein (1990); Prendergast and Stole ¨
(1996) and Dasgupta and Prat (2006).



3
in section 3 which is then simulated in section 3.3. Lastly, I conclude the paper in section
4 with some remarks on alternative theories.
2 Empirical analysis

2.1 Data sources
The database population is defined as all countries that experienced at least one default in
1975-2005. Default events are defined according to Standard & Poor's general definition as the
failure to meet a principal or interest payment on the due date (or within the specified grace
period) contained in the original terms of a debt issue (Beers and Chambers, 2006). I identify the
years when an economy first enters default on foreign bank, foreign bond and local currency
debt, and search Lexis-Nexis for news reports on the default event to
establish the month in which default is declared.
2

These default events are mapped into a detailed electoral history of leaders and po- litical
parties compiled for each country using the African Elections Database, Database of Political
Institutions, Georgetown Political Database of the Americas, Bingham Uni- versity Election
Results Archive and Adam Carr's Electoral Archive.
3
An example of a complete electoral history
is given in Appendix A for Costa Rica.
For leaders without concern for the democratic process it is difcult to measure a strategic
reaction.
4
In addition, Enderlein et al. (2011) argue that the stance of gov- ernments towards
private creditors depends on whether the government is democratic or autocratic, suggesting it is
more appropriate to study the strategic reactions of autocracies separately. Therefore, the focus of
this paper is on the timing of defaults where political accountability is determined through
regular democratic elections. Using the Polity IV democracy indicator, I sub-select country-years
when this measure is greater than -3.
5
In order to ensure comparison across a homogenous
elected group, I separate out default decisions taken by a leader who was not elected, for example
those who came to power when an incumbent resigned or died.

2
In
began.

the single case of Mongolia in 1997, it was not possible to find evidence for the month in which the default
3
Some further details were gleaned from University of Essex' database on Political Transformation and the Electoral Process
in Post-Communist Europe, UC San Diego's Latin American Election Statistics database and Wikipedia. I checked the timing of
electoral terms against the data of Brender and Drazen (2008), where our countries and time periods overlapped.
4
See Dhillon and Sjostrom (1997) for some theoretical work comparing democratic and autocratic default decisions.
5
This is slightly diferent from the alternative (equally arbitrary) cut-of of zero more frequently used in the political economy
literature, but it has no efect on the qualitative results of the paper. I choose this cutof to include a few extra default decisions
that were taken by leaders on the boundary of democracy/autocracy and would otherwise be excluded.



4
Table 1: Descriptive statistics of database


per country per country
Number of countries 36
Years of democracy 689 19.1 Years in default 253 7.03
Elections 174 4.83 Defaults 57 1.58
New incumbents 132 3.67 'New' Defaults 45 1.25


Table 1 shows there are 36 countries in which default by a democratically elected
leader has been recorded by Standard & Poor's. For these countries in total 174 elections took
place and of those elections 132 (76%) returned new incumbents to ofce. Since most countries
have a two-term limit for leadership, this is not a surprisingly high proportion. Although these
countries spent a total of 253 years of democracy in default (37%), there were only 57 distinct
periods when they entered into default on either foreign currency bank, foreign currency bond,
or domestic currency debt. Moreover, only 45 of these declarations of default occurred when the
country was not already in a state of default on some other obligations. I consider this latter group
to be 'new' or 'surprise' defaults since the other 12 occurred in periods of time that had already
been demonstrably financially stressful for the political leadership.



2.2 The timing of default over electoral cycles
The objective of this section is to investigate whether there is any evidence of patterns
in the timing of sovereign default over electoral terms in ofce. There are prior empirical reasons
why we should expect the risk of default to vary over the electoral cycle, but it is not clear
whether we should expect more defaults to occur just before an election or just after a new
incumbent is given leadership.
To allow common comparison, given cross-country variation in the length of a term in ofce,
I divide each electoral cycle into four quarters. A quarter may correspond to a period of time
ranging from one year (Costa Rica) to 1.5 years (Mexico), because electoral term length varies
between countries. I assume every elected leader takes ofce expecting to retain power for four
quarters of an electoral term.
Default events are mapped into the expected quarter of terms in ofce. Suppose, for example, a
leader defaults in the twelfth month of a four year incumbency. Then, even if she resigns in her
second year, the default is classified as occurring in the first quarter of her expected term in ofce.
A complete table of defaults events, detailing country, year and quarter of electoral cycle may be
found in Appendix B.


5
Leaders may not remain in power for all four quarters of their expected term in ofce,
for example they may resign, die naturally or be assassinated, so we expect to observe more early
quarters in the data.
6
This systematic pattern would cause us to observe more defaults in earlier
quarters if defaults occurred with equal probability in all quarters. To control for this, I also
compute and report in Table 2 the number of defaults relative to the number of quarters of all
electoral leaders in the database during the period 1975-2005.
The expected quarters of terms in ofce are separated according to whether the politi- cian is
newly elected (first term) or has been re-elected. I report the division for all 57 defaults by an
elected leader, and also for the 'new' defaults that occurred when the country was not already in
a state of default. Finally, although the data frequency limit the strength of any conclusions, I
also report the timing of default separately for parlia- mentary and presidential leaders. The
literature has already documented a distinction between the willingness of these two groups to
enter default (Kohlscheen, 2007; 2010), and it is therefore natural to investigate if there are
diferences in their timing of default
that might reveal strategic diferences between them.
7

Simply counting the raw data suggests that there are more defaults occurring in lead- ers' first
terms and earlier in those terms. However, the figures in parentheses show that, when scaled by
their respective populations, there's no indication that new politicians pre- fer to default over re-
elected incumbents, or that they are choosing to default early or late in their expected terms of
ofce. In addition, the data show that no real distinctions can be drawn from the separation of the
timing of defaults by presidential and parliamentary leaderships.
Finally, some leaders remain in power for two or more electoral terms, and patterns may be
present over their second or subsequent terms of ofce because, for example, their political power
has been well established. The second column in Table 3 shows the frequency of defaults over
the entire lives of politicians. As in the previous case, however, we expect to observe more early
quarters in the data as, systematically, more politicians are in power for early quarters. Once this
is controlled for, using the same population measure as before, column four in the same table
shows there is no significant diference
in the timing of defaults over electoral lives.
8

6
Occasionally,

leaders may stay in ofce beyond their expected term length by delaying calling an election.
This causes the fourth quarter of their expected incumbency to be longer than the other quarters, but there is no systematic data
pattern that will afect the results.
7
Kohlscheen (2010) finds that presidential democracies are more likely to default and argues that constitutional diferences
mean presidents need not worry about losing votes of no confidence in their leadership.
8
As a robustness exercise, I repeated the analysis of this section using the data of Arteta and Hale (2008), which yielded no
new information in relation to the timing of defaults. The tabulations of results are in Appendix E.


6
Table 2: Timing of sovereign defaults over electoral cycles


All Defaults 'New' Defaults
first term re-elected first term re-elected
Q1 16 (0.13) 4 (0.10) 10 (0.08) 4 (0.10)
Q2 10 (0.08) 4 (0.10) 9 (0.07) 3 (0.08)
Q3 7 (0.06) 4 (0.11) 7 (0.06) 3 (0.08)
Q4 9 (0.09) 3 (0.10) 6 (0.06) 3 (0.10)
Q corresponds to an expected quarter of a term in ofce
Figures in parentheses are % of respective population


Parliamentary Presidential New
Defaults New Defaults
first term re-elected first term re-elected
Q1 3 (0.06) 3 (0.16) 7 (0.09) 1 (0.05)
Q2 6 (0.13) 0 (0.00) 3 (0.04) 3 (0.15)
Q3 1 (0.02) 1 (0.06) 6 (0.09) 2 (0.11)
Q4 2 (0.06) 1 (0.07) 4 (0.06) 2 (0.13)
Q corresponds to an expected quarter of a term in ofce
Figures in parentheses are % of respective population

Table 3: Timing of defaults over leaders' electoral lives


Parliamentary Presidential
All Defaults 'New' Defaults
New Defaults New Defaults
Q1 15 (0.13) 10 (0.09) 3 (0.07) 7 (0.10)
Q2 11 (0.10) 10 (0.09) 6 (0.15) 4 (0.06)
Q3 9 (0.09) 8 (0.08) 1 (0.03) 7 (0.11)
Q4 10 (0.11) 6 (0.07) 2 (0.06) 4 (0.07)
Q5 2 (0.07) 2 (0.07) 2 (0.17) 0 (0.00)
Q6 3 (0.11) 3 (0.11) 1 (0.08) 2 (0.13)
Q7 3 (0.12) 2 (0.08) 0 (0.00) 2 (0.15)
Q8 3 (0.13) 3 (0.13) 1 (0.10) 2 (0.15)
Q9 1 (0.09) 1 (0.09) 1 (0.20) 0 (0.00)
Q corresponds to an expected quarter of a term in ofce
Figures in parentheses are % of respective population


2.3 Default in good and bad times
In this section, I show that there is no evidence that the defaults occurring during good
times, defined according to a variety of diferent measures, are correlated with early periods of
political tenure. This finding contradicts one implication of theories that postulate that



7
sovereign debt repayment depends on the 'type' of the government - that all defaults in
'good' times must occur in the early stages of the political incumbency. This is because political
leaders of 'good' types either never default, or do so only in 'bad' times, whereas political leaders
of 'bad' types will default at any time and be the only type to default in good times.
9
Therefore,
all defaults in good times must occur in the early stages of political incumbency, since bad types
will default promptly on taking power.
Table 4 shows the the timing of defaults using four diferent measures of good times. The first
measure follows Tomz and Wright (2007) in defining good times as those when country-specific
GDP growth is above trend, measured using a Hodrick-Prescott filter with a smoothing parameter
set to 6.25.
10
The remaining three measures consider threshold values of indicators commonly
used to signal a high debt burden - debt to export ratio above 20%, debt to GDP ratio above
200%, and reserve to debt ratio below 10%.
11
According to the literature discussed above, we
expect to see that any defaults that occur during good times (without crises) will be in the early
stages of a leader's incumbency. However, the columns show no evidence that defaults occurring
in good times are weighted
towards the earlier periods of an incumbency.
12
2.4 The efect of default on re-election
This section presents an analysis of the partial correlation between entering into a state
of default and the re-election of leaders that defaulted. It is not possible to identify the causal
efect of a default on the re-election probability of a particular leader because of the low frequency
of default events, and the absence of a convenient instrument. Nevertheless, the results address the
question of what happened to a leader who defaulted in a particular quarter of his incumbency.
Let c denote a particular country, and t a particular year. Equation 1 shows the reduced
form econometric specification used to identify the partial correlation of a default in a particular
quarter of an electoral term with a leader's re-election, where X represents

9
Eaton

(1996) is the earliest theoretical paper to consider imperfect information available to creditors on the
type of the government. His model suggests that all defaults would occur when the 'bad' type comes to power i.e. at the beginning
of an incumbency. Tomz (2007) allows for three types of borrower - the stalwart always repays, the fairweather defaults only in
'bad' times, and the lemon defaults in both 'bad' and 'good' times.
10Similar results were obtained when using a smoothing parameter of 100.
11All of these indicators are taken from the World Bank's Global Development Finance database; not all
countries in the sample have data available.
12As a robustness exercise, I repeated the analysis of this section using the data of Arteta and Hale (2008), which yielded no
new information in relation to the timing of defaults. The tabulations of results are in Appendix E.






8
Table 4: Timing of defaults in good and bad times


GDP Growth (6.25) Debt-export ratio Debt-GDP ratio Reserve-debt ratio
Good times Bad times Good times Bad times Good times Bad times Good times Bad times
(above trend) (below trend) (below 20%) (above 20%) (below 200%) (above 200%) (above 10%) (below 10%)
Q1 8 12 3 13 8 8 9 7
Q2 4 10 3 6 5 4 7
2Q3 5 6 5 6 6 5 8
3Q4 7 5 3 7 3 7 4
6
Total (share) 24 (0.42) 33 (0.58) 14 (0.30) 32 (0.70) 22 (0.48) 24 (0.52) 28 (0.61) 18 (0.39)
Q corresponds to an expected quarter of a term in ofce


Timing of 'new' defaults in good and bad times

GDP Growth (6.25) Debt-export ratio Debt-GDP ratio Reserve-debt ratio
Good times Bad times Good times Bad times Good times Bad times Good times Bad times
(above trend) (below trend) (below 20%) (above 20%) (below 200%) (above 200%) (above 10%) (below 10%)
Q1 5 9 2 8 5 5 6 4
Q2 3 9 2 5 4 3 5
2Q3 5 5 4 6 5 5 8
2Q4 5 4 3 5 2 6 3
5
Total (share) 18 (0.40) 27 (0.60) 11 (0.31) 24 (0.69) 16 (0.46) 19 (0.54) 22 (0.63) 13 (0.37)
Q corresponds to an expected quarter of a term in ofce
9

a vector of control variables ando are country and year fixed efects.

4
½(re-election)
c,t
= |
j
½(default in Q
j
)
c,t
+¸X
c,t
+o
c
+o
t
+?
c,t
(1 )
j =1


The vector of control variables is based on those used by Brender and Drazen (2008)
in their investigation into the relation between government spending, economic growth and
political re-election.
13
The level and change in government final consumption expenditure,
together with growth in GDP per capita are all obtained from the World Bank's database on World
Development Indicators. The ratio of debt to GDP is obtained from the World Bank's database
on Global Development Finance. In addition, I control for the level of democracy in a country
using the quantitative measure 'polity' from the Polity IV Database. The lack of comprehensive
availability of data for all countries and time periods necessarily restricts the coverage of this
analysis and is the cause of the relatively lower number of observations. Additional restriction is
imposed by requiring that the incumbent is eligible for election; this is important whenever term
limits exist, since they legally prevent the re-election of certain incumbents.
The second column of Table 5 contains the result from an analysis using Ordinary Least
Squares (OLS) and shows there is no significant relationship between the state of being in default
and the probability of re-election, measured using a dummy variable for the years in which the
economies were already in default. The third to fifth columns show the weak positive partial
correlation between entering into a state of default and the probability of re-election. The eighth
and ninth show similar results using logit and probit models; there is insufcient variation in both
default and re-election in the presence of country fixed efects so they are necessarily omitted. For
comparison, the seventh column shows the OLS results without country fixed efects.
As an additional investigation, I replace the dependent variable measuring the re- election of
individual leaders with a dummy variable for the re-election of the incumbent political party.
Since a political party may be re-elected even when a political leader may not (term limits do not
apply), there is an increase in the number of observations available for study. The fifth column
shows that there is no significant relationship between the re- election of political parties and
entering a state of default, suggesting that the individual

13The

analysis in this paper is diferent because Brender and Drazen (2008) analyse movements in variables in
the year(s) around elections, whereas I consider defaults by quarter of expected incumbency, and the year-length of quarters varies
by country. This might be a concern if agents are myopic and only recall the most recent year of their lives, but it seems reasonable
that voters would recall when a leader took power and the major decisions - such as an external debt default - taken during their
entire incumbency. When considering the efect of major
decisions on the outcome of an election, one should then account for the entire term, not just proximate years.


10
leader is more important than party leadership in the minds of voters when an economy
has just entered into default.
2.5 Anecdotal evidence on defaulters
The purpose of this section is to highlight key features of defaulting countries from three
anecdotes that will be used to motivate a simple model that explains the empirical facts
uncovered in the previous section. The features are that, first, a new incumbent typically inherits a
debt burden; second, debt burdens do not have a common origin and this has implications for the
default decision; and third, leaders that default may be re-elected. I relate the three anecdotes in
reverse chronological order.
2.5.1 Dominican Republic, 2005
The incumbent government dealt with the banking crisis of 2003-4 by converting private
sector losses into public sector debt, and printing money. The ensuing exchange rate
depreciation caused GDP in dollar terms to fall which, together with the rise in debt, led to a
dramatic increase in the debt-to-GDP ratio. Weak fiscal policies by the incumbent
government further undermined confidence. Leonal Fern´ndez took power in August 2004 a
and implemented reforms including a new tax package, cheaper oil from Venezuela, and in April
2005 restructured bond issues in an investor-friendly exchange. He was re-elected in August 2008.
The following is an extract from the IMF's 2009 Article IV consultation:


A financial crisis in 2003 (fueled by the failure of several fraud-ridden
banks) led to a generalized loss of confidence and a major bailout that doubled public debt. An
SBA [Stand-by Arrangement] (2003-05) went quickly of-track.
However, confidence improved after President Fern´ndez took ofce in mid- a
2004 and his new administration designed a strong economic program supported by another SBA
(2005-08) that successfully stabilized the economy. President
Fern´ndez was re-elected in 2008 and continued with broadly adequate macro a
policies...


2.5.2 Suriname, 2001
The Surinamese economy began to weaken in 1999 and, in a response designed to re-
stimulate it, Jules Wijdenbosch, the incumbent leader, loosened monetary and fiscal poli- cies
which generated a large amount of public debt. Rather than spend the raised debt on productive
investment, however, he chose to spend it on civil service wages which gener- ated in?ation.
Wijdenbosch chose not to run in the 2000 election that saw his closest rival in the previous
election, Ronald Venetiaan, become the new incumbent. Venetiaan im-


11
Table 5: The correlation between defaults and re-elections

Est. Method O LS O LS O LS O LS O LS O LS Logit Probit
Dep. Var. [1] [1] [1] [1] [2] [1] [1] [1]

Q1 0.215 0.262** 0.263** -0.0567 0.394** 3.214** 1.719**
(0.168) (0.116) (0.126) (0.215) (0.198) (1.347) (0.710)
Q2 0.229 0.0903 0.0944 0.0944 0.225 1.583* 0.827
(0.177) (0.183) (0.184) (0.162) (0.156) (0.941) (0.553)
Q3 0.0778 -0.0112 -0.0082 -0.0082 -0.0274 -0.286 -0.228
(0.153) (0.139) (0.114) (0.143) (0.192) (1.039) (0.671)
Q4 0.0814 0.121 0.131 0.1305 0.6085*** 5.002*** 2.940***
(0.155) (0.184) (0.201) (0.139) (0.182) (1.275) (0.764)
In default 0.0039
(0.0671)

Debt/GDP -0.0003 -0.0006 -0.00045 -0.0018*** -0.0002 -0.0015 -0.0011
(0.0005) (0.0006) (0.0006) (0.0007) (0.0004) (0.0021) (0.0013)
GDP Growth 0.0557 0.0068 0.0699 0.0699 0.0404 0.343* 0.194*
(0.0801) (0.0058) (0.0820) (0.075) (0.033) (0.178) (0.105)
Govt. Exp. 0.0126 0.0086 0.0236*** 0.0236*** 0.180*** 0.101***
(0.0074) (0.006) (0.008) (0.007) (0.0468) (0.0252)
Polity IV -0.0257 -0.0044 -0.0103 -0.0381*** -0.342*** -0.186***
(0.0207) (0.0277) (0.0149) (0.0142) (0.117) (0.0571)
GDPPC Gr. -0.0580 -0.0630 -0.058 -0.0456 -0.368** -0.206*
(0.0838) (0.0855) (0.0745) (0.0346) (0.188) (0.110)

Observations 307 209 175 172 238 172 162 162
R-squared 0.171 0.106 0.311 0.328 0.570 0.320

Country FE Y Y Y Y Y N N N
Year FE Y Y Y Y Y Y Y Y
Dep. Var. [1] Dummy variable = 1 if incumbent leader is re-elected
Dep. Var. [2] Dummy variable = 1 if incumbent political party is re -elected
Robust standard errors in parentheses
*** p<0.01, ** p<0.05, * p<0.1
1
2


mediately restructured the economy, including the public debt, and restored the economy
to a more stable footing. He was re-elected five years later. The following is an extract
from the IMF's 2001 Article IV consultation:


After experiencing steadily declining but positive rates of growth in the
period 1996-98, the Surinamese economy contracted in 1999 and 2000. The performance of the
economy in these two years was marked by falling activity levels and high in?ation. In particular,
real GDP excluding the informal sector is estimated to have fallen 8 percent in 2000. ...
The stance of fiscal and monetary policies remained loose in the first seven months of 2000.
In the run up to the May 2000 elections, the authorities granted large pay increases to civil servants,
and central bank resources provided most of the financing for the fiscal deficit. After losing the
elections, the out- going government utilized the transition period to pay of large election-related
expenses.
Almost immediately after taking ofce in August, the new administration
took action to address the economy's severe imbalances.


2.5.3 Macedonia, 1992
The Former Yugoslav Republic of Macedonia (FYRM) declared independence from So-
cialist Federal Republic of Yugoslavia (SFRY) in September, 1991. Immediately, there were
difculties allocating external liabilities, especially as other constituent members of SFRY chose
the same time to declare independence. An agreement on allocation was reached with SFRY,
under the new president Kiro Gligorov, and renegotiation via Paris and London Clubs allowed
them become eligible for IDA assistance and permitted them to restructure their long-term low-
rate debt. Gligorov was re-elected in 1994. The following
is an extract from the IMF's 1995 Staf Country Report No. 95/50:


All debt servicing payments were suspended at the time of monetary
independence in April 1992, payments to the Fund were resumed in February 1993, current
payments to the Fund were resumed in February 1993, current payments to the World Bank were
resumed in October 1993 and arrears to the Bank were cleared in February 1994; all payments to
ofcial bilateral creditors and commercial banks have remained suspended.
The breakup of the SFRY created significant difculties in the allocation
of external liabilities among the individual republics. The FYRM has accepted


13
to assume the part of the debt of the former SFRY that can be allocated among
the republics of the former SFRY according to the residency of the original borrower. The FYRM
has also accepted, as a temporary solution until there is a permanent agreement on the division of
assets and liabilities of the former SFRY, to assume 5.4 percent of the portion of the debt owed to
ofcial bilateral creditors that cannot be allocated according to the residency of the original borrower.
Discussions have been initiated with the Paris Club Secretariat on an early normalization of
relations with ofcial bilateral creditors. Negotiations with commercial banks on the FYRM's share
of the commercial debt of the former SFRY are still at an early stage.


The first thing to highlight from the previous anecdotes is a leader's inheritance of
debt incurred by a predecessor. It is natural for a leader to take charge of a country's economic
afairs and inherit the credit burdens of previous leaders. However, in most models of sovereign
default the agent that contracts the debt, usually the central planner, is also the one that defaults.
A richer political economy framework would allow diferent leaders to contract and default on
debt and, in particular, for leaders to inherit a high debt burden.
Second, these anecdotes illustrate two diferent origins of high debt burdens. In Suriname,
Wijdenbosch raised a large debt, but squandered the proceeds unproductively. This example
serves as an illustration of circumstances where a large amount of debt is contracted in a period
of time when there are insufcient productive projects available to generate returns sufcient to
repay the debt. In Macedonia, by contrast, debt was contracted when assets were thought to be
available to cover repayments and it was a change in external circumstances that led to a
shortfall. This illustrates cases where productive projects are available to generate sufcient
returns to repay debt but exogenous factors (these include natural disasters, as well as severe
political change) mean the debt is burdensome to repay.
Third, and finally, these anecdotes serve as examples where a leader takes a decision to
default and is re-elected. This goes against the postulated theory in the sovereign debt literature
that argues political costs in the form of lost elections or power are motivation for leaders to
repay sovereign debts. The model set out in the next section captures the features of sovereign
debt and political economy highlighted by these anecdotes, and delivers results that correspond
to those of the empirical section of the paper.





14
3 Modeling political career concerns about debt and default

3.1 Debt and default process
To combine sovereign default issues and political career concerns in one model necessarily
requires gross simplifications of both. I first provide a stylised procedure for sovereign debt
accumulation and default, and embed the process in a standard model of experts with career
concerns to study the efect on politicians' decisions.
The first step is to define the normative level of debt that the economy ought to hold. To
simplify the underlying processes that lead to particular levels of debt being
normatively optimal, there will be only two levels of debt: ·> d
H
> d
L
> 0, and I
will parameterise the optimal level of debt by denoting it with d
-
e {d
L
, d
H
}. For the t
moment, d
-
is given and, at the end of this section, I describe the process that gives rise t
to the specific value for d
-
. t
A natural question is why accumulating a relatively high level of debt is ever nor-
matively desirable. There are many economic motives for accumulating debt, including growth
opportunities, infrastructure investment and consumption smoothing. However, almost all
reasons for debt accumulation have an associated risk that the country will be required to repay
the debt from sources other than those in which the debt was invested, which may be too
demanding in an economy with scarce resources. In some cases, the risk associated with high
debt may optimally be accepted in exchange for faster recovery following a crisis, stronger
growth, or speedier transition to a steady state. This leads to cases where it is sometimes optimal
to have high debt, but it's not always clear when
those times are.
14

In addition to condensing the debt accumulation process, I simplify the normative state of
default present in virtually all sovereign debt models, where states of the world exist in which it
is utility-maximising, or welfare optimal, to default depending on the amount of debt owed to
creditors. Simplifying this process to only two cases, let the state
of the world be a
-
e {0, 1} where a
-
= 0 is the state where it is welfare optimal to default.
t t
The probability a default is welfare optimal depends on the amount of debt previously
contracted by the economy. First,ì
L
e (0, 1) represents the probability that it is some-
times welfare optimal to default (a
-
= 0) when the inherited debt level is high (d
t
÷
1
= d
H
), t
even though debt should have been high from a socially optimal perspective (d
-
÷
1
= d
H
). t

14A

developing economy may borrow and invest productively to accelerate growth, but the same borrowing
may be squandered on white elephants or lost to corruption. This was noted at least as early as Fetter (1947), but has been more
recently discussed in the context of Latin America, especially Brazil, (Cline, 1995, pp. 14-17) and the Heavily Indebted Poor
Countries borrowing during the 1970's (Greene, 1989).



15
This is to capture the idea that sometimes shocks occur that render it socially optimal to
default on debt that was previously optimal to hold - for example defaulting on the debt
owed for building a road subsequently destroyed by an earthquake.
15

Second,ì
H
e (0, 1) represents the probability that default is the socially optimal
action when debt was actually high (d
t
÷
1
= d
H
) but it was welfare optimal for it to be
low (d
-
÷
1
= d
L
). This captures the idea that, sometimes, it is optimal to default when a t
country has 'over-accumulated' debt.
16
It is assumed that the probability it is optimal to
default when there is excess debt is greater than the probability it is optimal to default
when debt is high and it was optimal to be so:ì
H
>ì
L
. More technically:


pr(a
-
= 0,d
t
÷
1
= d
L
, d
-
÷
1
= d
H
) = pr(a
-
= 1,d
t
÷
1
= d
L
, d
-
÷
1
= d
L
) = 1
t t t t
pr(a
-
= 0,d
t
÷
1
= d
H
, d
-
÷
1
= d
H
) =ì
L
e (0, 1)
t t
pr(a
-
= 0,d
t
÷
1
= d
H
, d
-
÷
1
= d
L
) =ì
H
e (ì
L
, 1)
t t


Finally, a process explaining the optimal level of debt d
-
is required. Unlike the t
optimal default decision, which depends on the previous period's variables, the optimal
level of debt is related to the current state of the world. In particular, I assume for tractability
that if it is optimal to default in the current period, then it is always also optimal to have a low
level of debt in that period.
17
In contrast, when it's not optimal
to default in the current period there is an exogenous probability of
1
?
2
that contracting
high debt is the optimal action.


pr(d
-
= d
H
,a
-
= 0) = 1 ÷ pr(d
-
= d
L
,a
-
= 0) = 0
t t t t
pr(d
-
= d
H
,a
-
= 1) = 1 ÷ pr(d
-
= d
L
,a
-
= 1) =


3.2
t

Political Economy
t t t
1
/2
Simplifying underlying economic processes permits a focus on the decisions of politicians,
a technique commonly used in the literature studying experts with career concerns to

15In

this light, default on debt that was previously optimal to hold may be viewed as a implicit contingency of
incomplete sovereign debt contracts (Zame, 1993). The optimality of this action may or may not be observable to the creditors,
but it needs to be so for the voters.
16Overaccumulation of debt is present in Perotti (1996) and Borensztein et al. (2005), and cross-country em- pirical evidence
for overaccumulation may be found in Mendoza and Ostry (2008).
17Aside from tractability, it is not unreasonable for an agent that defaults to expect, albeit temporary, exclu- sion from capital
markets - implying an imposition of low debt levels by creditors (Richmond and Dias, 2008; Sandleris et al., 2004). In
anticipation of this exclusion, the decision maker should expect only to obtain low debt in the aftermath of a default decision and,
if the decision itself were optimal, it makes sense that the low debt as part of that decision ought also to be optimal.



16
deal with the troublesome forward looking nature of these models.
18
In each period, the
politician decides (1) whether or not to default and, (2) the level of debt to contract. Let
the action of default be represented by a
t
e {0, 1} where a
t
= 0 is the action of default.
A politician receives exogenous fixed rents, R > 0, from ofce and seeks only to
maximise the probability of re-election. To achieve this aim, they make decisions to maximise
the welfare of voters, which is assumed to be a utility function with a bliss point at the optimal
level of debt and default decision. As a specific functional form,
welfare is assumed to be given by:


u
t
÷ ÷(a
t
÷ a
-
)
2
÷o(d
t
÷ d
-
)
2
t t


Whereo is the relative importance of obtaining an accurate decision on the level of debt
over the accuracy of the decision to default. The functional form of utility is such that,
once u
t
is observed, all agents can determine {a
-
, d
-
} which is important information for
voters.
19
t t
3.2.1 Timing of game

Having observed {a
t
÷
1
, d
t
÷
1
, u
t
÷
1
} all agents can infer d
-
÷
1
and, using the specified pro- t
cesses described above, determine the probability the economy is in a particular state.
Politicians inherit the debt of the previous period and make a decision whether or not to default
on it; if they do not default, repayment occurs. They then decide the amount of debt to contract.
Finally, these decisions determine social welfare which is observed by all. These processes
together constitute one period of time, and are represented in the
diagram below:

Figure 1: Timing of information and decisions in the model

1 2 3 4
Wake up Default decision: Debt decision: {a
t
, d
t
, u
t
}
knowing a
t
e {÷1, 1} d
t
e {d
H
, d
L
} observed
(d
t
÷
1
, d
-
÷
1
) t


In principle, elections may be held after any number of periods, however, an increase

18Typically in this literature, an expert is someone who knows the state of the world while an incompetent agent has some
incentive to pretend to know the state of the world. Other examples of models of experts with ca-
reer concerns include Holmstr¨m and Ricart i Costa (1986); Scharfstein and Stein (1990); Prendergast and Stole o
(1996) and Dasgupta and Prat (2006).
19The functional form also suggests that not defaulting when you should is just as socially bad as defaulting when you
shouldn't. This is purely a simplification however, representing the ubiquitous feature in sovereign default models that adverse
shocks to output, interest rates, terms of trade, etc induce states of the world in which it is optimal to default (Arellano, 2008;
Guimaraes, 2011; Foley-Fisher, 2011).


17
in periods makes the computation of agents' strategies exponentially complex. For the
purpose of this paper, I assume elections take place at the end of every period.
3.2.2 Politician's information structure
There are assumed to be two diferent types of politician, those that are competent and
those that are incompetent. There is a large mass of politicians, of which a commonly known
fraction µ are competent. A competent politician is assumed to know both their
type and the welfare optimal actions regarding the debt and default decisions: {a
-
, d
-
}.
t t
An incompetent politician knows their type but does not know {a
-
, d
-
}. Incompetent
t t
politicians have the same information set as voters and everyone learns what the socially
optimal choice would have been after a certain amount of time. The 'average' person does not
know what the socially optimal choice is beforehand, but a number of expert politicians do have
better ex-ante knowledge of the optimal choice. The information sets
of both types may be summarised as follows:

Competent politicians know: O
c
÷ {a
-
, d
-
, d
t
÷
1
, d
-
÷
1
, a
-
÷
1
, a
t
÷
1
}
t t t t

Incompetent politicians know: O
n
÷ {d
t
÷
1
, d
-
÷
1
, a
-
÷
1
, a
t
÷
1
}
t t

Since politicians always know their type, the socially optimal solution is for them to
admit (in)competence. Voters would then retain competent politicians and welfare would
be maximised in every period: u
t
= 0 ¬ t. Assuming that politicians can only hold
power for a fixed number of terms in ofce there would still be leadership turnover. The
incompetent politician has an incentive to pretend that s/he is competent to obtain the fixed rents
from being in power.
Voters randomly select a politician and observe the politician's actions and their own
utility: {a
t
, d
t
, u
t
}. The selected politician is given power for one period and receives
exogenous fixed rents from being in power, which means it is optimal for her to maximise
her probability of re-election. Voters want a competent politician in ofce and will only reelect
one when their posterior belief that she is competent, given debt and default decisions, is higher
than the probability that a random new politician drawn from the population is competent, i.e.
their prior.
The competent politician is assumed always to choose correctly and, since they always know
the correct choices, welfare under their leadership will always be zero, thereby always ensuring
re-election since the posterior belief of competence, given correct actions, will always be greater
than the prior.
20
Provided the incompetent politician is lucky enough

20There

may be equilibria where the competent politician systematically chooses incorrectly, but I focus on
'non-perverse' equilibria (Scharfstein and Stein, 1990).


18
to appear competent, s/he too will be re-elected.

Proposition 3.2.1 Suppose d
t
÷
1
= d
H
. There exists a perfect Bayesian equilibrium,
when the probability that default is the optimal action is sufciently small (ì
J
< 1/3),
where the incompetent politician never defaults, randomises over the choice of debt, and
is re-elected with positive probability. A competent politician knows she is always correct and, because we are
looking for a reasonable-strategy solution, will always take the correct
action.
21


P r o of
The equilibrium concept is perfect Bayesian equilibrium, where competent politicians
choose welfare maximising strategies, incompetent politicians choose strategies to max- imise
the probability they will retain power, and voters form beliefs about the probability that the
incumbent is competent and their beliefs are correct in equilibrium. The steps
can be summarised as follows:

1. Derive voters' beliefs given strategies and observed outcomes:


(ˆ,a
t
, d
t
, u
t
) µ


2. Compute expected payofs for politicians of type j as a function of their strategies,
given voters' beliefs:


R if (ˆ,a
t
, d
t
, E[u
t
])> µ

t(a
t
, d
t
,O
j

µ
0 otherwise
3. Determine politicians' optimal strategies, given diferent parameter values, and show
voters' beliefs are consistent with these strategies

Observe that when d
-
÷
1
= d
L
, the only parameter relevant to default isì
H
; whereas when t
d
t
÷
1
= d
H
, the only parameter isì
L
. It is therefore convenient to let J˜ = H when J = L; -
and J˜ = L when J = H. Then define the time-invariant probabilities that the politician
takes certain actions as follows:


q
J
˜
÷ pr(a
t
= 1,d
t
÷
1
= d
H
; d
-
÷
1
= d
J
˜
) e [0, 1] t
s ÷ pr(d
t
= d
H
,a
t
= 1) e [0, 1]

21For

the purpose of this paper, the equilibrium of this Proposition is sufcient but, for completeness, Appendix
C shows the existence of a perfect Bayesian equilibrium in a low debt environment, i.e. when dt÷
1
= d
L
.


19
The first step in the solution is to derive voters' posterior subjective belief that the
politician is competent. The voters update their prior belief that the politician is com- petent (µ)
by observing the decisions taken and their own welfare, and employing Bayes'
Rule. Denoting ˆ as this posterior belief, we obtain: µ



(1 / 2 )(1 ֓
J
)µ

(1/2)(1 ÷ì )µ + (1 ÷ µ)qJ
˜
s(1/2)(1 ֓ )
if a
t
= 1; d
t
= d
H
; u
t
= 0



J J







(1/2)(1 ÷ì )µ + (1 ÷ µ)q
J
˜
(J1 ÷ s)(1/2)(1 ÷ì )





J
(1 / 2 )(1 ÷ì )µ
J
if a
t
= 1; d
t
= d
L
; u
t
= 0
µ






ì
J
µ + (1 ÷ µ)(1 ÷ q
J
˜
)ì
J
ì
J
µ

if a
t
= 0; d
t
= d
L
; u
t
= 0









0

if u
t
= 0
These posterior beliefs update the prior probabilities that the actions taken by the
politician are the correct ones, thus accounting for the probability that the politician may indeed
be competent.
Taking voters' beliefs as given, incompetent politicians can compute the payof they
expect to receive as a function of any strategy pair they may take,t(a
t
e {0, 1}; d
t
e
{d
H
, d
L
}), based on the probability that they may be correct and thereby be re-elected:

t(a
t
= 1; d
t
= d
H
) = 1 ֓
J
R½(ˆ> µ) µ
2
t(a
t
= 1; d
t
= d
L
) = 1 ֓
J
R½(ˆ> µ) µ
2
t(a
t
= 0; d
t
= d
L
) =ì
J
R½(ˆ> µ) µ


From these expected payofs, and supposing ˆ> µ in all cases (verified below), an incom- µ
petent politician will never default ifì
J
<
1
/3, since the payof from defaulting is expected
to be lower than the payof from not defaulting: q
J
˜
-
= 1. In addition, since the payofs to
either level of debt are identical, the politician will pursue a mixed strategy
22
: s
-
e (0, 1).

22The importance of the assumption that pr(d
-
= d ,a
-
= 1) = 1 ÷ pr(d
-
= d ,a
-
= 1) =
1
/2 becomes apparent
t Ht t Lt
here, but note that it is necessary only to induce the incompetent politician to randomise over actions in this simplified model. In
a more complicated model the underlying intuition would still survive. For example, where the space of debt actions were a
continuum, and the competent politician retained a perfect signal of the socially optimal debt level, the incompetent politician
would want to randomise rather than always choose the same point based on some prior distribution. Similarly, if both types
received informative, but imprecise, signals, then the strategic reaction would be for the incompetent politician to take actions in
an efort to appear competent (Levy,


20
The final step is to show that s
-
e (0, 1) is consistent with voters' beliefs and their
re-election strategies, given the actions of incompetent politicians:




µ

µ + ( 1 ÷ µ ) s
-

if a
t
= 1; d
t
= d
H
; u
t
= 0






µ

µ

if a
t
= 1; d
t
= d
L
; u
t
= 0
µ + ( 1 ÷ µ ) ( 1 ÷ s
-
)







1

if a
t
= 0; d
t
= d
L
; u
t
= 0
which are all strictly greater than µ when s
-
e (0, 1) thereby verifying that this is an equilibrium.




3.3 Simulation
In order to demonstrate the intuition from the model, I suppose some values for the pa-
rameters and tabulate the results to compare to the empirical findings. For robustness, Appendix
D reports results from several alternative parameterisations. To generate polit- ical turnover,
suppose there are term limits of two periods. Although there are elections in every period, even a
competent politician will be removed from ofce following their second period in power.
Table 6 below contains the parameter values used in the simulation. According to
Proposition 3.2.1, any s
-
e (0, 1) is consistent with the perfect Bayesian equilibrium, however, the intuition
from the model is most consistent with the data when incompetent politicians have a tendency to
overaccumulate debt (this assumption is congruous with the anecdotes of Section 2.5).

Table 6: Parameter values for model simulation


Parameter Value Parameter Value
ì
H
0.25 µ 0.6
ì
L
0.15 s
-
0.6


Table 7 summarises the history of actions and socially optimal actions when the model
is simulated over 1,000 terms of ofce. The first row reports the number of times during the 1,000
terms when it was socially optimal to default; the second line reports the actual

2005).


21
number of default decisions that were taken, showing the calibration produces about one
default for every twenty-five terms of ofce. The number of times when it was socially optimal to
default is higher in first terms than in second terms because incompetent agents have a tendency
to over-accumulate debt in the times when they are in power, which raises the probability that
default is the socially optimal action in subsequent terms when they have lost power and a new
incumbent is in place. The overaccumulation of debt is observable from the last two lines of the
Table, the third line shows that in the new terms of politicians, there were 263 periods where it
was socially optimal to take out high level of debt, but the fourth line shows that high debt was
actually contracted in 291 periods. Comparing this to second terms in ofce, we see relatively less
overaccumulation because there are fewer incompetent politicians in power for a second term.

Table 7: Default and debt decision simulation results

Variable
Default states
Default decision
High debt states
High debt decision

First term
40
21
263
291

Second term
24
16
206 225


Section 2.2 showed that when the number of defaults was scaled by the number
of politicians in a particular quarter in ofce, the ratio was the same across electoral quarters. In
an analogous calculation, Table 8 shows the history of Table 7 relative to the total number of
political terms in ofce. Since there are incompetent politicians who are given power for a single
term, but are not re-elected, there are more first term than second term politicians. When the
number of actual defaults are scaled by the number of
politicians, the relative frequency of defaults across terms in ofce are the same.
23


Table 8: Simulation results relative to political terms

Variable
Default states
Default decision
High debt states
High debt decision

First term
0.071
0.037
0.467
0.517

Second term
0.055
0.037
0.471
0.515


Section 2.4 showed some weak empirical evidence that the politicians who defaulted

23Of

course, this model does not explicitly capture the number of politicians who leave during their terms
of ofce but, from Table 3, it is evident how the end of electoral terms are the most important threshold for politicians to cross.


22
were also the ones more likely to be re-elected. The equilibrium of Proposition 3.2.1 shows
that when there is a very low probability that actually defaulting is the socially optimal action to
take, incompetent politicians will shy away from entering into default. By contrast, a competent
politician will recognise the social benefit from defaulting and, by taking the decision at the right
time, will be re-elected. Table 9 shows the intuition in the simulation of the model for this result.
All the decisions to default are made by competent politicians who take the socially optimal
decision and are subsequently re-elected.

Table 9: Simulation results relative to political terms by political competence

Incompetent politician Competent politician
Variable First term Second term First term Second term
Default states 0.081 0.073 0.064 0.049
Default decision 0.000 0.000 0.064 0.049
High debt states 0.470 0.486 0.465 0.466
High debt decision 0.590 0.661 0.465 0.466



4 Concluding remarks
As noted by Panizza et al. (2009), although the theoretical importance of political econ-
omy considerations to sovereign default decisions has been postulated, comparatively little
empirical work has been undertaken to verify or test alternative mechanisms. In part this is due to
data limitations, both in cross-country political economy data and sovereign de- fault data. This
paper is no exception, and is challenged by these limitations to identify causal channels.
Nevertheless, whatever small contributions can be made are valuable to understanding the
broader canvas of sovereign default processes, especially in light of recent events in European
sovereign debt markets.
The first two empirical findings presented in this paper are in contrast to game theo- retic
explanations for political decisions to default. In particular, the absence of evidence that sovereign
defaults in good times are occurring early in political incumbency is con- trary to theories where
some types of government treat the decision to default diferently.
The third finding, of a weak positive correlation between default and subsequent re-
election, stands in contrast to intuition that political costs may explain why sovereign debt is ever
repaid, and existing empirical evidence (Borensztein and Panizza, 2010). Of course the realisation
of political costs may not be observed in equilibrium because they serve as an out-of-equilibrium
threat point (Grossman and Van Huyck, 1988). The finding does suggest however that there may
be another mechanism whereby those who actually do default are also more likely to be re-
elected though, since the result is purely a correlation,


23
it emphatically does not suggest that those who default will improve their chances of re-
election. And since it's not possible to identify causality empirically, I turn to model-based
explanations.
The model I derive is based on an intuition that defaulting politicians reveal infor- mation on
their competence and are therefore more likely to be re-elected by voters. Of course there may be
alternative explanations for the empirical facts, for example, that a political leader does not
default because it makes her a likeable member of the inter- national community, and a good
international reputation re?ects well on the domestic economy. Then, when the domestic
economy wants to default, the leader can utilise her international reputation to obtain a non-too-
costly default, and domestic voters recognise the value of having a reputable leader with re-
election. These alternative explanations show there is obvious scope for future work to derive
contrarian empirical predictions from these alternative models, and empirically investigate their
respective veracity.



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26
Q'sof Total Q's
Year Country Type of Govt. Election Leadership exp. term of leader Month Reason Leader Re-election Term
in ofce in ofce re-elected possibility limits
1975 Costa Rica Presidential 0 No 4
1976 Costa Rica Presidential 0 No 4
1977 Costa Rica Presidential 0 No 4
1978 Costa Rica Presidential 1 1 4 4 May Election 0 No 4
1979 Costa Rica Presidential 0 No 4
1980 Costa Rica Presidential 0 No 4
1981 Costa Rica Presidential 0 No 4
1982 Costa Rica Presidential 1 1 4 4 May Election 0 No 4
1983 Costa Rica Presidential 0 No 4
1984 Costa Rica Presidential 0 No 4
1985 Costa Rica Presidential 0 No 4
1986 Costa Rica Presidential 1 1 4 4 May Election 0 No 4
1987 Costa Rica Presidential 0 No 4
1988 Costa Rica Presidential 0 No 4
1989 Costa Rica Presidential 0 No 4
1990 Costa Rica Presidential 1 1 4 4 May Election 0 No 4
1991 Costa Rica Presidential 0 No 4
1992 Costa Rica Presidential 0 No 4
1993 Costa Rica Presidential 0 No 4
1994 Costa Rica Presidential 1 1 4 4 May Election 0 No 4
1995 Costa Rica Presidential 0 No 4
1996 Costa Rica Presidential 0 No 4
1997 Costa Rica Presidential 0 No 4
1998 Costa Rica Presidential 1 1 4 4 May Election 0 No 4
1999 Costa Rica Presidential 0 No 4
2000 Costa Rica Presidential 0 No 4
2001 Costa Rica Presidential 0 No 4
2002 Costa Rica Presidential 1 1 4 4 May Election 0 No 4
2003 Costa Rica Presidential 0 No 4
2004 Costa Rica Presidential 0 No 4
2005 Costa Rica Presidential 0 No 4
A

S
a
m
p
l
e

e
l
e
c
t
o
r
a
l

h
i
s
t
o
r
y

-

C
o
s
t
a

R
i
c
a


2
7


B Table of defaults by country


Table 10: Table of defaults by country

Default-election Electoral
Country
Antigua and Barbuda
Bolivia
Cook Islands
Costa Rica
Cote d'Ivoire
Croatia
Dominica
Dominican Rep.
Ecuador
Gambia
Grenada
Guatemala
Guatemala
Guyana
Indonesia
Jamaica
Jamaica
Jamaica
Kenya
Macedonia
Mexico
Moldova
Moldova
Nigeria
Nigeria
Nigeria
Pakistan
Peru
Senegal
Year
1996
1986
1995
1981
2000
1992
2003
2005
1999
1986
2004
1986
1989
1979
2002
1978
1981
1987
2000
1992
1982
1998
2002
1982
2001
2004
1998
1983
1990
quarter
Quarter 2
Quarter 1
Quarter 1
Quarter 3
Quarter 1
Quarter 2
Quarter 4
Quarter 1
Quarter 1
Quarter 4
Quarter 1
Quarter 1
Quarter 4
Quarter 4
Quarter 3
Quarter 1
Quarter 1
Quarter 3
Quarter 3
Quarter 1
Quarter 4
Quarter 1
Quarter 2
Quarter 3
Quarter 3
Quarter 2
Quarter 2
Quarter 3
Quarter 2
history
Election
Election
Incumbent re-elected
Election
Election
Incumbent re-elected
Election
Election
Election
Incumbent re-elected
Incumbent re-elected
Election
Election
Incumbent re-elected
Election
Incumbent re-elected
Election
Incumbent re-elected
Incumbent re-elected
Election
Election
Election
Election
Election
Election
Incumbent re-elected
Election
Election
Incumbent re-elected
Continued on next page



28
Table 10 - continued from previous page
Default-election Electoral
Country
Senegal
Serbia
Seychelles
Slovenia
South Africa
South Africa
Suriname
Trinidad and Tobago
Ukraine
Uruguay
Uruguay
Uruguay
Venezuela
Venezuela
Venezuela
Venezuela
Zimbabwe
Year
1992
1992
2000
1992
1985
1989
2001
1988
1998
1987
1990
2003
1983
1990
1995
2004
2000
quarter
Quarter 4
Quarter 1
Quarter 3
Quarter 2
Quarter 1
Quarter 4
Quarter 2
Quarter 2
Quarter 4
Quarter 2
Quarter 1
Quarter 3
Quarter 4
Quarter 2
Quarter 2
Quarter 3
Quarter 4
history
Incumbent re-elected
Incumbent re-elected
Incumbent re-elected
Election
Election
Election
Election
Election
Election
Election
Election
Election
Election
Election
Election
Election
Incumbent re-elected


























29
C Perfect Bayesian equilibrium in low debt environment

Proposition C.0.1 Suppose d
t
÷
1
= d
L
. There exists a perfect Bayesian equilibrium where the
incompetent politician randomises over the choice of debt, never defaults, and is re-elected with
positive probability. A competent politician knows she is always correct and, because we are looking for a reasonable -
strategy solution, will always take the correct action.


Using the same notation as in Section 3.2.1, the equilibrium is far simpler because, when d
t
÷
1
=
d
L
, there is no current state in which default is optimal. There is a single action a politician can
take, and the time-invariant probability is denoted by:


s ÷ pr(d
t
= d
H
,a
t
= 1) e [0, 1]


The voters' posterior subjective belief, ˆ, that the politician is competent given the observed µ
actions {a
t
, d
t
} are derived using Bayes' Rule:




(1/2)µ
(1/2)µ + (1 ÷ µ)s(1/2)
µ


if a
t
= 1 and d
t
= d
H




(1/2)µ + (1(1/2))µ1 ÷ s)(1/2)
÷µ (
if a
t
= 1 and d
t
= d
L
Taking voters' beliefs as given, incompetent politicians can compute the payof they can
expect to receive, as a function of their strategy on debt,t(a
t
= 1; d
t
e {d
H
, d
L
}), based on
the probability that they may be correct and thereby be re-elected:


t(a
t
= 1; d
t
= d
H
) =

1 R ½( ˆ> µ ) µ
2
t(a
t
= 1; d
t
= d
L
) =
1 R ½( ˆ> µ ) µ
2

Since the payofs to either level of debt are identical, the politician will pursue a mixed
strategy: s
-
e (0, 1). Given these actions, the voters' posterior beliefs are:



µ + (1 ÷ µ)s
-

µ
µ

if a
t
= 1 and d
t
= d
H


µ + (1 ÷ µ)(1 ÷ s
-
)


µ if a
t
= 1 and d
t
= d
L
which are all strictly greater than µ for s
-
e (0, 1), thereby verifying that this is an equilibrium.




30
D Alternative simulation parameterizations

D.1 ì
h
= 0 .1 5 ,ì
l
= 0 .0 5 , µ = s
-
= 0 .6


Table 11: Default and debt decision simulation results

Variable
Default states
Default decision
High debt states
High debt decision

First term
21
15
278
298

Second term
12
8
205
225


Table 12: Simulation results relative to political terms

Variable
Default states
Default decision
High debt states
High debt decision

First term
0.038
0.027
0.497
0.533

Second term
0.027
0.018
0.465
0.510


D.2 ì
h
= 0 .2 0 ,ì
l
= 0 .1 5 , µ = s
-
= 0 .6


Table 13: Default and debt decision simulation results

Variable
Default states
Default decision
High debt states
High debt decision

First term
41
20
266
296

Second term
35
29
195
196


Table 14: Simulation results relative to political terms


Variable
Default states
Default decision
High debt states
High debt decision


First term
0.072
0.035
0.469
0.522


Second term
0.081
0.067
0.450
0.453








31
D.3 ì
h
= 0 .2 5 ,ì
l
= 0 .0 5 , µ = s
-
= 0 .6


Table 15: Default and debt decision simulation results

Variable
Default states
Default decision
High debt states
High debt decision

First term
40
23
258
296

Second term
9
6
231
239


Table 16: Simulation results relative to political terms

Variable
Default states
Default decision
High debt states
High debt decision

First term
0.072
0.041
0.463
0.531

Second term
0.020
0.014
0.521
0.540


D.4 ì
h
= 0 .2 5 ,ì
l
= 0 .2 0 , µ = s
-
= 0 .6


Table 17: Default and debt decision simulation results

Variable
Default states
Default decision
High debt states
High debt decision

First term
71
38
256
295

Second term
43
33
191
204


Table 18: Simulation results relative to political terms

Variable
Default states
Default decision
High debt states
High debt decision

First term
0.126
0.067
0.454
0.523

Second term
0.099
0.076
0.438
0.468










32
D.5 ì
h
= 0 .3 5 ,ì
l
= 0 .1 5 , µ = s
-
= 0 .6


Table 19: Default and debt decision simulation results

Variable
Default states
Default decision
High debt states
High debt decision

First term
58
33
262
312

Second term
22
16
208
216


Table 20: Simulation results relative to political terms

Variable
Default states
Default decision
High debt states
High debt decision

First term
0.102
0.058
0.461
0.549

Second term
0.051
0.037
0.481
0.500


































33
E Analysis using Arteta and Hale (2008) data
The tables in this Appendix repeat the analysis of Section 2 using the database generously
provided by Carlos Arteta and Galina Hale. In this database, however, there is no recorded history of
default episodes, so it is not possible to separate 'new' entries into default episodes. This means that the set
of defaults are not fully comparable to those obtained from the Standard and Poor's database.
Table 21: Database descriptive statistics

per country per country
Number of countries 27
Years of democracy 551 20.41
Elections 138 5.11 Defaults 55 2.04
New incumbents 116 4.3


Table 22: Timing of sovereign defaults over electoral cycles


All Defaults


Parliamentary
Defaults


Presidential
Defaults
first term re-elected first term re-elected first term re-elected
Q1 19 (0.17) 1 (0.05) 3 (0.11) 1 (0.11) 16 (0.19) 0 (0.00)
Q2 11 (0.10) 0 (0.00) 3 (0.13) 0 (0.00) 8 (0.10) 0 (0.00)
Q3 5 (0.05) 3 (0.16) 1 (0.05) 2 (0.22) 4 (0.05) 1 (0.10)
Q4 10 (0.11) 6 (0.35) 1 (0.07) 1 (0.14) 9 (0.12) 5 (0.50)
Q corresponds to an expected quarter of a term in ofce
Figures in parentheses are % of respective population


Table 23: Timing of defaults over leaders' electoral lives




Q1
Q2
Q3
Q4
Q5
Q6
Q7
Q8
Q9


All Defaults

18 (0.17)
12 (0.12)
5 (0.05)
12 (0.14)
0 (0.00)
1 (0.06)
2 (0.14)
1 (0.08)
0 (0.00)


Parliamentary
Defaults
2 (0.07)
5 (0.21)
1 (0.05)
1 (0.06)
0 (0.00)
1 (0.20)
1 (0.20)
0 (0.00)
0 (0.00)


Presidential
Defaults
16 (0.20)
7 (0.09) 4
(0.06)
11 (0.16)
0 (0.00) 0
(0.00) 1
(0.10) 1
(0.10) 0
(0.00)
Q corresponds to an expected quarter of a term in ofce
Figures in parentheses are % of respective population



34
Table 24: Timing of defaults in good and bad times


GDP Growth (6.25) Debt-export ratio Debt-GDP ratio Reserve-debt ratio
Good times Bad times Good times Bad times Good times Bad times Good times Bad times
(above trend) (below trend) (below 20%) (above 20%) (below 200%) (above 200%) (above 10%) (below 10%)
Q1 8 12 6 11 4 13 8 8
Q2 4 7 2 9 1 10 6
5Q3 3 5 1 5 1 5 1
6Q4 10 6 5 10 6 9 8
7
Total (share) 25 (0.45) 30 (0.55) 14 (0.29) 35 (0.71) 12 (0.25) 37 (0.75) 23 (0.47) 26 (0.53)
Q corresponds to an expected quarter of a term in ofce
3
5



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