Capital controls may lead to higher sustainable levels of public debt
Economies with the most underdeveloped financial markets are the ones that can sustain high public debt levels. The underlying reason is that the use of capital controls in these countries reduces the incentives of sovereign default. Lower default incentives increase the levels of public debt that can be considered sustainable.
In his doctoral dissertation Spyridon Sichlimiris explain the public debt of developing countries. The level of development of financial markets in these countries is an important element to understand their public debt sustainability.
− Capital controls are a form of financial repression for an economy. They force local investors to buy local assets. "Moreover, they contribute to divide the public debt market into a domestic and a foreign segment, says Spyridon Sichlimiris."
In this way governments captivate local bondholders and can exploit arbitrage opportunities across segmented markets. Foreign bondholders are willing to extend loans to such type of governments because they know that it is a costly option for these governments not to pay their public debt.
− My study shows that such types of economies can sustain higher levels of public debt under capital controls rather than liberalized capital flows. Some of these insights may be useful to understand the recent events of the Greek debt crisis, says Spyridon Sichlimiris.
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