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Optimal Sovereign Default

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  • Adam, Klaus
  • Grill, Michael

Abstract

When is it optimal for a government to default on its legal repayment oblig- ations? We answer this question for a small open economy with domestic production risk in which the government optimally finances itself by issuing non-contingent debt. We show that Ramsey optimal policies occasionally devi- ate from the legal repayment obligation and repay debt only partially, even if such deviations give rise to significant default costs. Optimal default improves the international diversification of domestic output risk, increases the efficiency of domestic investment and - for a wide range of default costs - significantly increases welfare relative to a situation where default is simply ruled out from Ramsey optimal plans. We show analytically that default is optimal following adverse shocks to domestic output, especially for very negative international wealth positions. A quantitative analysis reveals that for empirically plausible wealth levels, default is optimal only in response to disaster-like shocks to do- mestic output, and that default can be Ramsey optimal even if the net foreign asset position is positive.

Suggested Citation

  • Adam, Klaus & Grill, Michael, 2012. "Optimal Sovereign Default," Working Papers 12-16, University of Mannheim, Department of Economics.
  • Handle: RePEc:mnh:wpaper:32508
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    Cited by:

    1. Stefan Niemann & Paul Pichler, 2017. "Collateral, Liquidity and Debt Sustainability," Economic Journal, Royal Economic Society, vol. 127(604), pages 2093-2126, September.
    2. Thomas McGregor, 2017. "Pricing sovereign debt in resource rich economies," OxCarre Working Papers 194, Oxford Centre for the Analysis of Resource Rich Economies, University of Oxford.
    3. Trebesch, Christoph & Zabel, Michael, 2017. "The output costs of hard and soft sovereign default," European Economic Review, Elsevier, vol. 92(C), pages 416-432.
    4. Rieth, Malte, 2014. "Myopic governments and welfare-enhancing debt limits," Journal of Economic Dynamics and Control, Elsevier, vol. 38(C), pages 250-265.
    5. Fabrice Collard & Michel Habib & Jean-Charles Rochet, 2015. "Sovereign Debt Sustainability In Advanced Economies," Journal of the European Economic Association, European Economic Association, vol. 13(3), pages 381-420, June.
    6. Michael Kumhof & Romain Ranciere & Pablo Winant, 2013. "Inequality, Leverage and Crises; The Case of Endogenous Default," IMF Working Papers 13/249, International Monetary Fund.
    7. repec:eee:dyncon:v:85:y:2017:i:c:p:1-20 is not listed on IDEAS

    More about this item

    JEL classification:

    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems

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