Sovereign Debt: Default, Market Sanction, and Bailout
AbstractThis paper explores the case of a sovereign indebted country facing a choice of economic policy today that will determine the country's ability to continue its debt servicing in the future. If the sovereign undertakes an unsound economic policy it will repudiate its debt with certainty; otherwise it will repudiate its debt with some positive probability. In our framework there is no court to enforce contracts. However, we assume the existence of a multilateral financial institution that could bailout the financially troubled sovereign country. Our focus is on the incentives created by the perspective of a bailout, as well as the punishment that the international financial markets could impose on the defaulting country, on today's economic policy. This essay provides a theoretical grounding for the IMF and other multilateral agencies intervention on the international financial markets showing that, unlike the idea that bailouts create both debtor and creditor moral hazard, it is sometimes a result of creditors' overreaction to the prospect of a liquidity crisis. The main result of the essay is that the multilateral will be better off bailing out the country regardless of the economic policy undertaken in order to avoid bigger losses from a generalized financial crisis
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Date of creation: 11 Aug 2004
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sovereign debt; default; bailout; creadible threat; market sanction;
Find related papers by JEL classification:
- F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions
- F34 - International Economics - - International Finance - - - International Lending and Debt Problems
- D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
This paper has been announced in the following NEP Reports:
- NEP-ALL-2004-10-30 (All new papers)
- NEP-FIN-2004-10-30 (Finance)
- NEP-IFN-2004-10-30 (International Finance)
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