Abstract
Sovereign debt crises in emerging markets are usually associated with liquidity and banking crises within the economy. This connection is suggested by both anecdotical and empirical evidence. The conventional view is that the domestic financial turmoil is caused by foreign creditors' retaliation. Yet, there is no clear-cut evidence supporting the existence of \classic" default penalties (e.g., trade sanctions or exclusion from international capital markets). This paper then proposes a novel mechanism linking sovereign defaults with liquidity and banking crises without any intervention of foreign creditors. The model considers a standard unwillingness-to-pay problem assuming that: (i) the enforcement of private contracts is limited and, as a result, public debt represents a source of liquidity; (ii) the government cannot discriminate between domestic and foreign agents. In this setting, the prospect of drying up the private sector's liquidity restores the ex-post incentive to pay of the government without any need to assume foreign penalties. Nonetheless, liquidity crises might arise when economic conditions deteriorate and the government chooses opportunistically to default in order to avoid the repayment of foreign agents. The interaction between the enforcement friction and sovereign risk is then exploited to study the implications on international capital flows and legal and institutional domestic reforms.
Log Value Added (y). Log of value added in US dollars at the 3-digit ISIC classification for manufacturing sectors. Data are sourced from the UNIDO INDSTAT 2005 database. Original data are deated using the GDP deator in
Default Dummy (DEF). Dummy variable taking a value one in the first year of a default episode. Data on default episodes are sourced from the Standard and Poor's sovereign default database, as reported in Beers and Chambers (2002). This database includes all sovereign defaults on loans or bonds with private agents between 1975 and 2002, and reports the period during which the debtor government remained in default.
Financial Dependence (FinDep). An index constructed as the median share of capital expenditures not financed with the cash ow from operations (capital expenditures minus cash flow from operation divided by capital expenditures) by US-based, publicly listed firms. The index is sourced from Kroszner et al. (2007), who provide a 3-digit ISIC based reclassification of the data originally constructed by Rajan and Zingales (1998) for a mixture of 3-digit and 4-digit ISIC sectors. The data refer to the period 1980-1999 and, originally, range from -1.14 (Tobacco) to 0.72 (Transport equipment), with a higher number indicating greater financial dependence. To ease statical inference, I normalize the index such that it ranges from 0 to 1.
Liquidity Needs (Liq). An index constructed as the median ratio of inventories over total sales for US-based, publicly listed firms. This index has been initially proposed by Raddatz (2006) to measure industrys financial needs that focuses on short-term liquidity needs. The data are sourced from Kroszner et al. (2007), who compute the Raddatz index for the 3-digit ISIC manufacturing sectors. The data refer to the 1980s and, originally, range from 0.07 (Tobacco) to 0.72 (Plastic Products), with a higher number indicating greater financial dependence. To ease statical inference, I normalize the index such that it ranges from 0 to 1.
Tangibility (Tangs). An index constructed as the median ratio of net property, plant and equipment to total assets by US-publicly listed firms during the period 1980-1999 in each 3-digit ISIC manufacturing sector. The data are sourced from Kroszner et al. (2007). The original data range from 0.12 to 0.62, and are normalized such that they range from 0 to 1.
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