Edoardo Grillo (Collegio Carlo Alberto)

“Strategic Sovereign Defaults under International Sanctions”

abstract

Economic sanctions are often used to destabilize hostile political regimes. We present a model where targeted regimes react to sanctions by initiating a public debt crisis to foster internal political support. The strategy is based on two considerations. Fist, sanctions increase the share of external debt on GDP and reduce the internal costs of default. Second, public debt default quickly frees up financial resources that can be allocated to increase political support or to repress opposition. We test the model empirically on a dataset on sanctions and sovereign debt defaults. We find that 38% of all debt crises recorded during the 1960-2005 period happened during economic sanctions. Sanctions are associated with a 4 to 12 percentage point increase in risk of sovereign default, and we find evidence that countries that default under sanctions tend to enter in default at better levels of economic performance than other countries in debt crisis. Political leaders who default under sanction experience an 8 percentage point increase in probability of remaining in office. The relationship between sanctions and debt crises remains strong even after we account for causality using IV estimation. Thus, our findings suggest that sanctions can be a costly tool of foreign policy, and they also may be quite ineffective in the presence of large external debt.