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Efficient frameworks for sovereign borrowing

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  • Irwin, Gregor

    (Bank of England)

  • Thwaites, Gregory

    (Bank of England)

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    Abstract

    This paper presents a theoretical model of strategic default to assess how national and international policymakers should seek to influence the cost of default and the distribution of bargaining power in the event of a default. We find that, in the absence of restrictions on the parameter space, deadweight costs of default should be driven to zero. Moreover, if the debtor is risk-averse, there is an optimal division of bargaining power between the debtor and its creditors. Even with restrictions on the parameter space, marginally lower deadweight costs, possibly in some combination with greater creditor bargaining power, can always raise social welfare ex ante. However, once debt has been contracted, the debtor's trade-off between creditor bargaining power and deadweight costs changes fundamentally. In equilibrium, the deadweight costs of default may therefore tend to be too high, and the allocation of bargaining power inefficiently skewed towards the debtor. The challenge for policymakers is to find credible, time-consistent combinations of policies that can both reduce deadweight costs and shift bargaining power towards creditors.

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    Bibliographic Info

    Paper provided by Bank of England in its series Bank of England working papers with number 343.

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    Length: 33 pages
    Date of creation: Mar 2008
    Date of revision:
    Handle: RePEc:boe:boeewp:0343

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    Keywords: Sovereign debt; default; restructuring.;

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    1. Zame, William R, 1993. "Efficiency and the Role of Default When Security Markets Are Incomplete," American Economic Review, American Economic Association, vol. 83(5), pages 1142-64, December.
    2. Tao Zha, 2001. "Bankruptcy Law, Capital Allocation, and Aggregate Effects: A Dynamic Heterogenous Agent Model with Incomplete Markets," Annals of Economics and Finance, Society for AEF, vol. 2(2), pages 379-400, November.
    3. Grossman, Herschel I & Van Huyck, John B, 1988. "Sovereign Debt as a Contingent Claim: Excusable Default, Repudiation, and Reputation," American Economic Review, American Economic Association, vol. 78(5), pages 1088-97, December.
    4. Harold L. Cole & James Dow & William B. English, 1994. "Default, settlement, and signalling: lending resumption in a reputational model of sovereign debt," Staff Report 180, Federal Reserve Bank of Minneapolis.
    5. Patrick Bolton & Olivier Jeanne, 2005. "Structuring and Restructuring Sovereign Debt: The Role of Seniority," NBER Working Papers 11071, National Bureau of Economic Research, Inc.
    6. Jeremy I. Bulow & Kenneth Rogoff, 1987. "A Constant Recontracting Model of Sovereign Debt," NBER Working Papers 2088, National Bureau of Economic Research, Inc.
    7. Federico Sturzenegger & Jeromin Zettelmeyer, 2007. "Debt Defaults and Lessons from a Decade of Crises," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262195534, December.
    8. Kris James Mitchener & Marc D. Weidenmier, 2005. "Supersanctions and Sovereign Debt Repayment," NBER Working Papers 11472, National Bureau of Economic Research, Inc.
    9. Franz Hamann, 2002. "Sovereign Risk and Macroeconomic Fluctuations," BORRADORES DE ECONOMIA 003520, BANCO DE LA REPÚBLICA.
    10. Misa Tanaka, 2005. "Bank loans versus bond finance: implications for sovereign debtors," Bank of England working papers 267, Bank of England.
    11. Frankel, Jeffrey, 2005. "Contractionary Currency Crashes In Developing Countries," Working Paper Series rwp05-017, Harvard University, John F. Kennedy School of Government.
    12. Van Wijnbergen, Sweder, 1990. "Cash/debt buy-backs and the insurance value of reserves," Journal of International Economics, Elsevier, vol. 29(1-2), pages 123-131, August.
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