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Decentralized Borrowing and Centralized Default

  • Yun Jung Kim

    (University of Michigan)

  • Jing Zhang

    (University of Michigan)

In the past, foreign borrowing by developing countries was comprised almost entirely of government borrowing. Recently, private firms and individuals in developing countries borrow substantially from foreign lenders. It is not clear whether the observed increase in private sector borrowing leads to overborrowing and frequent defaults by governments in developing countries. In this paper, we develop a tractable quantitative model in which private agents decide how much to borrow but the government decides whether to default. The model with decentralized borrowing increases aggregate credit costs and sovereign default risk, and reduces aggregate welfare, relative to a model with centralized borrowing. Private agents do not internalize the effect of their borrowing on economy-wide credit costs and thus would like to borrow more than the socially efficient level. Depending on the severity of default penalties, decentralized borrowing may lead to either too much or too little debt in equilibrium. The introduction of decentralized borrowing substantially improves the model's empirical fit in terms of matching observed debt levels and default rates.

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File URL: http://www.fordschool.umich.edu/rsie/workingpapers/Papers576-600/r596.pdf
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Paper provided by Research Seminar in International Economics, University of Michigan in its series Working Papers with number 596.

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Length: 27 pages
Date of creation: Apr 2010
Date of revision:
Handle: RePEc:mie:wpaper:596
Contact details of provider: Postal: ANN ARBOR MICHIGAN 48109
Web page: http://fordschool.umich.edu/rsie/

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