External Debt, Capital Flight and Political Risk

Abstract

This paper explains the simultaneous occurrence of large external debts, private capital outflows and low domestic capital formation. We consider a general equilibrium model in which two government types with conflicting distributional goals randomly alternate in office. Uncertainty over the fiscal policies of future governments generates capital flight and small domestic investment, and induces the government to overaccumulate external debt. The model also predicts that left-wing governments are more inclined to restrict capital outflows than right-wing governments. Finally, we examine how political uncertainty affects the risk premium and how debt repudiation may occur after a regime change.