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Optimal External Debt and Default

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Author Info
Bernardo Guimaraes

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Abstract

This paper analyses whether sovereign default episodes can be seen as contingencies ofoptimal international lending contracts. The model considers a small open economy withcapital accumulation and without commitment to repay debt. Taking first orderapproximations of Bellman equations, I derive analytical expressions for the equilibriumlevel of debt and the optimal debt contract. In this environment, debt relief generated byreasonable fluctuations in productivity is an order of magnitude below that generated byshocks to world interest rates. Debt relief prescribed by the model following the interest ratehikes of 1980-81 accounts for a substantial part of the debt forgiveness obtained by the mainLatin American countries through the Brady agreements.

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Paper provided by Centre for Economic Performance, LSE in its series CEP Discussion Papers with number dp0847.

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Date of creation: Feb 2008
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Handle: RePEc:cep:cepdps:dp0847

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Related research
Keywords: sovereign debt; default; capital flows; optimal contract; world interest rates;

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Find related papers by JEL classification:
F3 - International Economics - - International Finance
F4 - International Economics - - Macroeconomic Aspects of International Trade and Finance
G1 - Financial Economics - - General Financial Markets

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  1. Alfaro, Laura & Kanczuk, Fabio, 2005. "Sovereign debt as a contingent claim: a quantitative approach," Journal of International Economics, Elsevier, vol. 65(2), pages 297-314, March. [Downloadable!] (restricted)
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  3. Eaton, Jonathan & Gersovitz, Mark, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, Blackwell Publishing, vol. 48(2), pages 289-309, April. [Downloadable!] (restricted)
  4. Marcet, Albert & Marimon, Ramon, 1992. "Communication, commitment, and growth," Journal of Economic Theory, Elsevier, vol. 58(2), pages 219-249, December. [Downloadable!] (restricted)
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  5. Cohen, Daniel & Sachs, Jeffrey, 1986. "Growth and external debt under risk of debt repudiation," European Economic Review, Elsevier, vol. 30(3), pages 529-560, June. [Downloadable!] (restricted)
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  6. Vivian Z. Yue, 2005. "Sovereign Default and Debt Renegotiation," 2005 Meeting Papers 138, Society for Economic Dynamics. [Downloadable!]
  7. Aguiar, Mark & Gopinath, Gita, 2006. "Defaultable debt, interest rates and the current account," Journal of International Economics, Elsevier, vol. 69(1), pages 64-83, June. [Downloadable!] (restricted)
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  8. Carmen M. Reinhart & Kenneth S. Rogoff, 2004. "Serial Default and the "Paradox" of Rich to Poor Capital Flows," NBER Working Papers 10296, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  9. Reinhart, Carmen & Rogoff, Kenneth & Savastano, Miguel, 2003. "Debt intolerance," MPRA Paper 13932, University Library of Munich, Germany. [Downloadable!]
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  10. Krugman, Paul, 1988. "Financing vs. forgiving a debt overhang," Journal of Development Economics, Elsevier, vol. 29(3), pages 253-268, November. [Downloadable!] (restricted)
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  11. Herschel I. Grossman & John B. Van Huyck, 1989. "Sovereign Debt as a Contingent Claim: Excusable Default, Repudiation, and Reputation," NBER Working Papers 1673, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  12. Michael Tomz & Mark L. J. Wright, 2007. "Do countries default in “bad times”?," Working Paper Series 2007-17, Federal Reserve Bank of San Francisco. [Downloadable!]
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  13. Yan Bai & Jing Zhang, 2006. "Financial Integration and International Risk Sharing," 2006 Meeting Papers 371, Society for Economic Dynamics. [Downloadable!]
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  15. Fernando Broner & Alberto Martin & Jaume Ventura, 2006. "Sovereign Risk and Secondary Markets," NBER Working Papers 12783, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  16. Rui Albuquerque & Hugo A. Hopenhayn, 2004. "Optimal Lending Contracts and Firm Dynamics," Review of Economic Studies, Blackwell Publishing, vol. 71(2), pages 285-315, 04. [Downloadable!] (restricted)
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  17. Atkeson, Andrew, 1991. "International Lending with Moral Hazard and Risk of Repudiation," Econometrica, Econometric Society, vol. 59(4), pages 1069-89, July. [Downloadable!] (restricted)
  18. Arellano, Cristina, 2008. "Default risk and income fluctuations in emerging economies," MPRA Paper 7867, University Library of Munich, Germany. [Downloadable!]
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  19. Bulow, Jeremy & Rogoff, Kenneth, 1989. "A Constant Recontracting Model of Sovereign Debt," Journal of Political Economy, University of Chicago Press, vol. 97(1), pages 155-78, February. [Downloadable!] (restricted)
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  20. Eduardo Borensztein & Paolo Mauro, 2004. "The case for GDP-indexed bonds," Economic Policy, CEPR, CES, MSH, vol. 19(38), pages 165-216, 04. [Downloadable!] (restricted)
  21. Natalia Kovrijnykh & Balázs Szentes, 2007. "Equilibrium Default Cycles," Journal of Political Economy, University of Chicago Press, vol. 115, pages 403-446. [Downloadable!] (restricted)
  22. Uribe, Martin & Yue, Vivian Z., 2006. "Country spreads and emerging countries: Who drives whom?," Journal of International Economics, Elsevier, vol. 69(1), pages 6-36, June. [Downloadable!] (restricted)
  23. Karsten Jeske, 2006. "Private International Debt with Risk of Repudiation," Journal of Political Economy, University of Chicago Press, vol. 114(3), pages 576-593, June. [Downloadable!] (restricted)
  24. Neumeyer, Pablo A. & Perri, Fabrizio, 2005. "Business cycles in emerging economies: the role of interest rates," Journal of Monetary Economics, Elsevier, vol. 52(2), pages 345-380, March. [Downloadable!] (restricted)
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  25. Dotsey, Michael & Lantz, Carl & Scholl, Brian, 2003. " The Behavior of the Real Rate of Interest," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 35(1), pages 91-110, February.
  26. Francesco Caselli, 2007. "The Marginal Product of Capital," The Quarterly Journal of Economics, MIT Press, vol. 122(2), pages 535-568, 05. [Downloadable!] (restricted)
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  27. repec:rus:hseeco:123922 is not listed on IDEAS
  28. Kletzer, Ken & Newbery, David M & Wright, Brian D, 1992. "Smoothing Primary Exporters' Price Risks: Bonds, Futures, Options and Insurance," Oxford Economic Papers, Oxford University Press, vol. 44(4), pages 641-71, October. [Downloadable!] (restricted)
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  29. 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. [Downloadable!] (restricted)
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  30. Fernandez, Raquel & Rosenthal, Robert W, 1990. "Strategic Models of Sovereign-Debt Renegotiations," Review of Economic Studies, Blackwell Publishing, vol. 57(3), pages 331-49, July. [Downloadable!] (restricted)
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