The Effects of Financial Liberalization on Sovereign Default Risk: A Continuous-Time Model of Sovereign Debt under Capital-Account Openness.
Fukui, Hirotaka (2026) The Effects of Financial Liberalization on Sovereign Default Risk: A Continuous-Time Model of Sovereign Debt under Capital-Account Openness. MPRA Paper 127909.
Type: Article
Abstract: Financial globalization has expanded access to external financing, yet liberalization is often followed by sharp spread spikes and renewed default risk. This paper studies how capital-account liberalization reshapes sovereign debt dynamics and default incentives. We develop a continuous-time sovereign default model with a transaction wedge capturing capital-account frictions. The wedge creates an endogenous no-trade band around pure rollover. When liberalization lowers the wedge, issuance becomes more frequent and aggressive. Because bond prices embed a debt-dilution term, greater issuance depresses prices and makes spreads more convex in output and global interest-rate shocks. These effects shift the default frontier inward and raise conditional default risk, highlighting a trade-off between borrowing flexibility and financial fragility.
Publication Status: Working Papers