Is it Punishment? Sovereign Defaults and the Decline in Trade.” Business School Working Paper 2008-01, Universidad Torcuato di Tella, Buenos Aires

The ability of creditors to impose trade sanctions has been one of the workhorse arguments to explain why governments repay foreign creditors. Although sovereign defaults are associated with declines in the defaulting country trade, the absence of explicit trade sanctions following defaults in recent decades is troublesome. One way in which the trade sanctions argument is reconciled with this evidence is to argue that creditor countries are punishing defaulting countries through sub rosa actions that disrupt their trade. Is this the case? Are trade sanctions (understood in a broad sense) causing the declines in trade? Using a gravity model framework we devise an empirical strategy to evaluate this issue. It is based on the idea that if trade sanctions are causing the declines, bilateral trade with creditor countries should fall more than trade with other countries. We find that sovereign defaults are associated with a decline in overall trade for the defaulting country. However, in the aftermath of defaults, there seems to be no evidence of a larger decline in bilateral trade with creditor countries affected by the default. This would imply that the declines are not due to punishments imposed by these creditor countries. The analysis does not yield evidence of broader punishment strategies including a league of major creditors (not just those affected by the default) either. These results would contradict the predictions of the trade sanctions theory of sovereign borrowing