Trade-off between international and domestic risk sharing in the presence of sovereign risk

This paper analyzes how sovereign risk affects government's ability to smooth domestic risk when policy tools imperfectly discriminate foreign and domestic agents. The government can-not choose to pay differently foreign and domestic bond holders; however it can imperfectly discriminate against foreign investors by reducing overall debt payments and lowering domestic tax burden accordingly. This paper shows that, in an overlapping generations economy with privately observable idiosyncratic risk, this distortion results in excessive consumption inequality in the cross-section of domestic agents and excessive consumption volatility in the time series. Opening the capital account enables international risk sharing, but also introduces this government's distortion. Its overall effect on consumption risk is therefore ambiguous.