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Default, Settlement, and Repayment History: A Unified Model of Sovereign Debt

  • Irani Arraiz
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    This paper combines default, settlement, and repayment history into a unified, dynamic borrowing model of sovereign debt. The model addresses two questions: 1) how the level of debt and the income profile affect the length of time a country in default is excluded from the international credit market, and 2) how repayment history impinges upon the credit limit and interest rate lenders offer, and upon the borrower's incentive to default. In the model, borrowers weigh the benefits from defaulting against the penalties associated with it, namely a lengthy exclusion from the market and a potential deterioration in the credit terms. The paper models the settlement as a random process to reflect inefficiencies that arise due to the existence of private information, but conditions the probability of a settlement on the portion of the defaulted debt borrowers agree to repay. The model incorporates repayment history (i.e., the number of years a country has been active in the international credit market) into the information set used by lenders. Quantitative analysis shows that the model can replicate some key stylized facts of sovereign debt: settlement offers depend positively on a debtor's current income level and negatively on its level of debt; the debt-to-GDP ratio that new borrowers or serial defaulters can support is well below the ratio that proven debtors can safely manage; the probability of default is larger for debtors with recent payment difficulties; once a country defaults, it takes many years of impeccable repayment and low levels of debt for that country to gain full access to international credit markets; this process is slow and backsliding is difficult to avoid

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    Paper provided by Society for Economic Dynamics in its series 2006 Meeting Papers with number 217.

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    Date of creation: 03 Dec 2006
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    Handle: RePEc:red:sed006:217
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