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Sovereign Debt: Default, Market Sanction, and Bailout

  • Paulo Augusto P. de Britto
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    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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    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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    1. Jonathan Eaton & Raquel Fernandez, 1995. "Sovereign Debt," NBER Working Papers 5131, National Bureau of Economic Research, Inc.
    2. repec:att:wimass:8813 is not listed on IDEAS
    3. Jonathan Eaton, 1991. "Sovereign Debt: A Primer," Boston University - Institute for Economic Development 21, Boston University, Institute for Economic Development.
    4. 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.
    5. 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.
    6. Rose, Andrew K, 2002. "One Reason Countries Pay Their Debts: Renegotiation and International Trade," CEPR Discussion Papers 3157, C.E.P.R. Discussion Papers.
    7. Jeremy Bulow & Kenneth Rogoff, 1998. "Sovereign Debt: Is to Forgive to Forget," Levine's Working Paper Archive 209, David K. Levine.
    8. Jonathan Eaton & Mark Gersovitz & Joseph E. Stiglitz, 1986. "The Pure Theory of Country Risk," NBER Working Papers 1894, National Bureau of Economic Research, Inc.
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