Sovereign Default and Coalition Formation

Abstract: There is strong empirical evidence that the likelihood of sovereign debt default and rescheduling in democratic developing countries is reduced when the government is composed of more than one political party. A major tenet of coalition formation theory is the minimal-winning coalition; however, the relative frequency of surplus coalitions in both developing and developed countries seems to run counter to this theory. This paper links sovereign default empirical evidence with coalition formation theory. It provides a formal theoretical explanation for the coalition effect in the probability of default, and for the formation of surplus coalitions. In a stochastic endowment economy, two parties rotate in power. They have the option to invite a third party, which represents that part of society which is more directly interested in retaining access to international borrowing markets, to form a coalition government. The presence of the smaller party in the coalition decreases the likelihood of default (coalition buys commitment), and hence, bond prices are higher. When the effect of higher bond prices dominates the redistributive effect of one more party in government, bigger political parties have an incentive to form a coalition, even when this is not necessary to guarantee majority support in the legislative body. The positive effect of coalitions on bond prices is strongest for a combination of GDP much below potential with a low level of borrowing.