New Department Working Paper

Sovereign spreads and the level of bureaucratic diversion of government spending vary widely across emerging economies and are correlated with each other. We build a sovereign default model where the government is constrained to use corrupt bureaucrats to deliver public goods and services in order to explain these facts. The diversion policy parameters are estimated using data on public resources and monitoring efficiency and used to calibrate the model. We use data on the average gift needed to be given to win public contracts in a country as a measure of bureaucratic diversion because it allows us to quantify diversion of public resources whereas tax evasion is hard to measure. We tie down the efficiency level to the Rule of Law index. We show that economies with low monitoring efficiency display higher diversion levels and higher default risk (and spreads) than those with higher efficiency. These results emerge because defaults reduce diversion levels and this benefit from default is higher for low monitoring efficiency economies, which encourages default.