Sovereign debt default: Are countries trapped by their own default history?
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Why are sovereign debt defaults so persistent in some EMEs, even at relatively low levels of external debt? The empirical literature has argued that the country s record of defaults is the main determinant of the future default risk. However, there are two factors generating the e¤ect from history on the probability of default: state dependence and unobserved heterogeneity. Is a country more likely to default because it has experienced a default in the past (state dependence) or does the country have some previous speci c characteristics that make it more prone to default (unobserved heterogeneity)? Results indicate that state dependence e¤ects are large. Nevertheless, this paper presents evidence indicating that the omission of unobserved heterogeneity -which accounts for both unobserved and observed time invariant characteristics- has drastic consequences when assessing countries risk of default. When unobserved het- erogeneity is accounted for there are countries with high risk of default even if negligible levels of debt are assigned to them. Conversely, other countries show a low probability of default even with assigned levels of indebtedness higher than those observed in the sample. Finally, this paper presents evidence suggesting that unobserved heterogeneity could be associated to a set of di¤erent historical, political, and cultural factors that have deeply and persistently shaped institutions.
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