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Sovereign Debt: Default, Market Sanction, and Bailout

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  • Paulo Augusto P. de Britto
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    Abstract

    This 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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    File URL: http://repec.org/esLATM04/up.14012.1082055378.pdf
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    Bibliographic Info

    Paper provided by Econometric Society in its series Econometric Society 2004 Latin American Meetings with number 237.

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    Date of creation: 11 Aug 2004
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    Handle: RePEc:ecm:latm04:237

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    Keywords: sovereign debt; default; bailout; creadible threat; market sanction;

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    1. Eaton, Jonathan & Gersovitz, Mark, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, Wiley Blackwell, vol. 48(2), pages 289-309, April.
    2. Jonathan Eaton & Raquel Fernandez, 1995. "Sovereign Debt," Boston University - Institute for Economic Development 59, Boston University, Institute for Economic Development.
    3. Eaton, Jonathan, 1993. "Sovereign Debt: A Primer," World Bank Economic Review, World Bank Group, vol. 7(2), pages 137-72, May.
    4. Andrew K. Rose, 2002. "One Reason Countries Pay their Debts: Renegotiation and International Trade," EUI-RSCAS Working Papers 18, European University Institute (EUI), Robert Schuman Centre of Advanced Studies (RSCAS).
    5. Eaton, Jonathan & Gersovitz, Mark & Stiglitz, Joseph E., 1986. "The pure theory of country risk," European Economic Review, Elsevier, vol. 30(3), pages 481-513, June.
      • Jonathan Eaton & Mark Gersovitz & Joseph E. Stiglitz, 1991. "The Pure Theory of Country Risk," NBER Chapters, in: International Volatility and Economic Growth: The First Ten Years of The International Seminar on Macroeconomics, pages 391-435 National Bureau of Economic Research, Inc.
    6. Bordo, Michael D. & Schwartz, Anna J., 2000. "Measuring real economic effects of bailouts: historical perspectives on how countries in financial distress have fared with and without bailouts," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 53(1), pages 81-167, December.
    7. Bulow, J. & Rogoff, K., 1988. "Sovereign Debt: Is To Forgive To Forget?," Papers 411, Stockholm - International Economic Studies.
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