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1. Hypothesized Links between Debt and Trade
One of the main puzzles in international finance is why countries ever repay their foreign
debts. A growing body of theory addresses this puzzle by modeling the incentives of borrowers
and lenders. According to some theorists, countries repay because the value access to future
loans and fear that default could sully their reputation in international capital markets.
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Others
emphasize that the threat of direct sanctions – trade embargoes or gunboat diplomacy –
motivates countries to honor their commitments.
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These two explanations are not mutually
exclusive, but they involve distinct causal mechanisms. To understand why defaults occur and
how they can be prevented, we must first determine whether and under what conditions each of
these two mechanisms is effective.
In numerous models, creditors enforce debt contracts by linking finance and trade. This
argument appears in the seminal work of Bulow and Rogoff (1989) and in more recent papers by
Aizenman (1991), Chang and Sundaresan (2002), Diwan (1990), Fernandez and Rosenthal
(1990), Gibson and Sundaresan (2002), Klimenko (2000), Lane (1999), and Rose and Spiegel
(2004), among many others. But how, exactly, could creditors interfere with the trade of a
foreign state? There are three possibilities: they could seize its foreign assets, prevent its citizens
from obtaining short-term credit for imports and exports, or impose trade barriers ranging from
higher tariffs to an outright embargo.
The first type of trade sanctions almost certainly has not played a significant role in the
enforcement of debt contracts. For centuries, courts in the major financial centers adhered to an
absolute doctrine of sovereign immunity, which made it impossible to attach the assets of a
foreign government. After the Peruvian default of 1875, for example, bondholders sought in the
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E.g. Eaton and Gersovitz (1981); Kletzer and Wright (2000).
3
E.g. Bulow and Rogoff (1989); Rose and Spiegel (2004).
Convention