It is common practice in the financial market to link a sovereign borrower’s credibility to his amount of outstanding debt: with increasing debt amount, default will be regarded as more likely, which in turn leads to increase in the borrowing cost. However, empirical research has revealed that this link differs substantially from country to country: while some countries can accumulate debt to as high as more than 100% of GDP and still enjoy a low interest cost, many developing countries are facing a fairly low debt threshold and must pay high risk premium even though their debt to GDP ratios are way below one.
This paper attempts to explain this phenomenon by taking a closer look at the lender-borrower-relationship. Our main finding is that the lender-borrower-relationship plays an important role in government borrowing through the voting right channel and a country with closer relationship to his average lender is less inclined to default on his sovereign debt compared to an otherwise identical country with looser relationship to his average lender. If this is correctly anticipated by the financial market, then the investors will offer to the former government a more favorable borrowing condition, i. e. lower borrowing cost and/or less borrowing constraint.
Our approach is thought to be complementary to the explanations from the existing literature which focus on other factors like debt level or GDP growth and we show that in average, keeping all other factors constant, a government with mainly domestic debt is less inclined to default than a comparable government with mainly external debt owed to some distant countries. Further we have tackled the "multiple equilibria" problem and have shown that our result is robust to it even under some fairly general assumptions.