DP13202 | Rare Disasters, Financial Development, and Sovereign Debt

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We study the implications of the interaction between rare disasters and financial development for sovereign debt markets. In our model, countries vary in their financial development, by which we mean the extent to which shocks can be hedged in inter- national capital markets. The model predicts that low levels of financial development generate a key feature of sovereign debt in emerging economies known as “debt intol- erance”: high credit spreads associated with lower debt-to-output ratios than those of developed countries.