An IPE Framework for Sovereign Risk

Abstract

As highlighted in Chapter 1, the existing literature suffers from an under-investigation of the role of politics in driving investment decisions. In the case of developed democracies in particular, the issue is often rapidly dismissed on the grounds that political institutions do not matter for portfolio allocation across those economies, since these institutions themselves are supposed to have contributed to eliminating sovereign risk. This assumption is particularly surprising in the case of sovereign debt markets, since sovereign risk has inherently political connotations. Moreover, in the presence of international financial markets with stronger financial and trade inter-linkages and, crucially, higher cross-border bond ownership, a wider web of interests is affected by a potential sovereign default decision. As a result, international political factors are also likely to play a role. The importance of international factors is further reinforced whenever the possibility of an international bail-out is introduced into the picture. Indeed, mainstream economists highlight the fact that the quality of political institutions is a fundamental determinant of a country’s debt tolerance level (Reinhart et al., 2003). Accordingly, economists and political scientists have made a few attempts at investigating the political features more or less conducive to default in emerging markets (for example Kohlscheen, 2007). However, there has been limited investigation of the role of politics in affecting risk premia in what are normally denominated “developed democracies”, including Euro area members, be these recent or long-standing “graduates” to the club.