Sovereign default, enforcement and the private cost of capital

•This paper studies the effect of sovereign debt and default on private credit.•Sovereign defaults trigger an increase on the private interest rate.•Higher levels of sovereign debt also increase private interest rates.•Lower state capacity augments the risk of sovereign default.•Impatient governments invest less in state capacity and default more often.

This paper develops a signaling model for a small open economy in which the government's sovereign debt repayment decision gives lenders new information regarding the state's capacity to enforce contracts. Contract enforcement affects the expected repayment of private loans. Therefore, if lenders receive negative information from the sovereign default about the state's capacity to enforce contracts, they worsen the financial conditions offered to local firms, triggering a sharp reduction in credit and investment. The key contribution of this paper is to rationalize the worsened private-sector financial conditions observed after default episodes by modeling the price effect of the informational channel.