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<BR>We show that cross-country differences in the underlying volatility and persistence of<BR>macroeconomic shocks help explain two historical regularities in sovereign borrowing: the<BR>existence of “vicious” circles of borrowing-and-default (“default traps”), as well as the fact<BR>that recalcitrant sovereigns typically face higher interest spreads on future loans rather than<BR>outright market exclusion. We do so in a simple model where output persistence is coupled<BR>with asymmetric information between borrowers and lenders about the borrower’s output<BR>process, implying that a decision to default reveals valuable information to lenders about the<BR>borrower’s future output path. Using a broad cross-country database spanning over a century,<BR>we provide econometric evidence corroborating the model’s main predictions-namely, that<BR>countries with higher output persistence and conditional volatility of transient shocks face<BR>higher spreads and thus fall into default traps more easily, whereas higher volatility of<BR>permanent output tends to dampen these effects.<BR>JEL Classification Numbers: F34, G15, H63, N20<BR>Keywords:<BR>Sovereign Debt, Default, Country Spreads, Output Volatility and Persistence.
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