Sovereign Risk and Secondary Markets

TLDR

Sovereign risk is traditionally believed to eliminate foreign asset trade when default penalties are absent. The study finds that foreign asset trade can persist without default penalties if secondary markets function, implying sovereign risk only harms trade when penalties are weak and markets are imperfect, and that strengthening penalties or market mechanisms can mitigate the risk. JEL codes: F34, G12, G15.

Abstract

Conventional wisdom says that, in the absence of default penalties, sovereign risk destroys all foreign asset trade. We show that this conventional wisdom rests on one implicit assumption: that assets cannot be retraded in secondary markets. Without this assumption, foreign asset trade is possible even in the absence of default penalties. This result suggests a broader perspective regarding the origins of sovereign risk and its remedies. Sovereign risk affects foreign asset trade only if default penalties are insufficient and secondary markets work imperfectly. To reduce its effects, one can either increase default penalties or improve the working of secondary markets. (JEL F34, G12, G15)