Sovereign debt capacity and the distribution of domestic wealth: a common agency problem

This paper proposes a stylized two-period two-country model illustrating the role played by the distribution of domestic wealth in determining a country’s level of access to international lending. We model sovereign debt redemption policy as the outcome of the interaction between the domestic government and interest groups (locals and foreigners) with conflicting preferences about debt repayment (common agency framework). The main result produced by our model is that, although discriminatory taxation against foreign bond-holders is not available and foreigners are allowed entering the process of buying influence, default is always ex-post observed when all domestic interests are represented and a share of sovereign debt is detained by foreigners. On the contrary, by assuming selective participation to lobbying, we show that a borrowing country’s access to international capital markets increases with inequality in the domestic distribution of wealth.