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Default Costs, Willingness to Pay and Sovereign Debt Buybacks

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  • Jonathan P. Thomas

    (University of St Andrews)

Abstract

The arguments put forward by Bulow and Rogoff (1988, 1991) against sovereign debt buybacks are re-examined in a willingness-to-pay framework. This paper argues that the Bulow-Rogoff framework treats default by a debtor as an event with no dead-weight loss, and, as such, underestimates the potential gains from a buyback. The willingness-to- pay framework allows dead-weight costs of default to be introduced in a consistent and simple fashion into the buybacks calculus. Two versions of this framework are considered. First, a model in which the default costs induce an all-or-nothing default decision is analysed. In this case, an ambiguous result is derived in which the variability of the debtor’s income determines whether (small) buybacks are beneficial to the debtor, even though expected total transfers to the creditor increase, consistent with Bulow-Rogoff. In a second version, default costs are modelled so as to induce at most a partial default. This model corresponds most closely, in terms of the repayment behaviour of the sovereign debtor, to the models used by Bulow and Rogoff. It is shown that small buybacks are always beneficial to the debtor in this case. The second version is extended to include an investment opportunity. Only if the country has sufficiently scarce resources when the investment can be made, will a buyback be harmful to the interests of the debtor.

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File URL: http://128.118.178.162/eps/if/papers/0103/0103002.pdf
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Bibliographic Info

Paper provided by EconWPA in its series International Finance with number 0103002.

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Length: 22 pages
Date of creation: 08 Mar 2001
Date of revision:
Handle: RePEc:wpa:wuwpif:0103002

Note: Type of Document - PDF; prepared on IBM-PC; pages: 22 ; figures: none. 22 pages, PDF
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Web page: http://128.118.178.162

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Keywords: Sovereign Debt Buybacks Sanctions Willingness to Pay;

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References

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  1. 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.
  2. Eaton, Jonathan, 1993. "Sovereign Debt: A Primer," World Bank Economic Review, World Bank Group, vol. 7(2), pages 137-72, May.
  3. Krugman, Paul, 1988. "Financing vs. forgiving a debt overhang," Journal of Development Economics, Elsevier, vol. 29(3), pages 253-268, November.
  4. Eaton, Jonathan, 1990. "Debt Relief and the International Enforcement of Loan Contracts," Journal of Economic Perspectives, American Economic Association, vol. 4(1), pages 43-56, Winter.
  5. Jeremy Bulow & Kenneth Rogoff, 1989. "Sovereign Debt Repurchases: No Cure for Overhang," NBER Working Papers 2850, National Bureau of Economic Research, Inc.
  6. Sachs, J. & Huizinga, H.P., 1987. "U.S. commercial banks and the developing-country debt crisis," Open Access publications from Tilburg University urn:nbn:nl:ui:12-155106, Tilburg University.
  7. Detragiache, Enrica, 1994. "Sensible buybacks of sovereign debt," Journal of Development Economics, Elsevier, vol. 43(2), pages 317-333, April.
  8. Rotemberg, Julio J., 1991. "Sovereign debt buybacks can lower bargaining costs," Journal of International Money and Finance, Elsevier, vol. 10(3), pages 330-348, September.
  9. 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.
  10. 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.
  11. Farazli, Jeannine M, 1998. "Profitable Buybacks in Sovereign Debt," Review of International Economics, Wiley Blackwell, vol. 6(4), pages 649-59, November.
  12. Paul R. Krugman, 1988. "Market-Based Debt-Reduction Schemes," NBER Working Papers 2587, National Bureau of Economic Research, Inc.
  13. 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.
  14. 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.
  15. William R. Cline, 1995. "International Debt Reexamined," Peterson Institute Press: All Books, Peterson Institute for International Economics, number 46.
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Cited by:
  1. Magdalena Polan & Parmeshwar Ramlogan & Carlos I. Medeiros, 2007. "A Primeron Sovereign Debt Buybacks and Swaps," IMF Working Papers 07/58, International Monetary Fund.

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