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Optimal external debt and default

  • Bernardo Guimaraes


This paper analyses whether sovereign default episodes can be seen as contingencies of optimal international lending contracts. The model considers a small open economy with capital accumulation and without commitment to repay debt. Taking first order approximations of Bellman equations, I derive analytical expressions for the equilibrium level of debt and the optimal debt contract. In this environment, debt relief generated by reasonable fluctuations in productivity is an order of magnitude below that generated by shocks to world interest rates. Debt relief prescribed by the model following the interest rate hikes of 1980-81 accounts for a substantial part of the debt forgiveness obtained by the main Latin American countries through the Brady agreements.

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Paper provided by Society for Economic Dynamics in its series 2007 Meeting Papers with number 104.

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Date of creation: 2007
Date of revision:
Handle: RePEc:red:sed007:104
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Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

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  1. Stefano G. Athanasoulis & Robert J. Shiller, 2001. "World Income Components: Measuring and Exploiting Risk-Sharing Opportunities," American Economic Review, American Economic Association, vol. 91(4), pages 1031-1054, September.
  2. Albert Marcet & Ramon Marimon, 1992. "Communication, commitment, and growth," Discussion Paper / Institute for Empirical Macroeconomics 74, Federal Reserve Bank of Minneapolis.
  3. Fernando Broner & Alberto Martin & Jaume Ventura, 2006. "Sovereign Risk and Secondary Markets," 2006 Meeting Papers 565, Society for Economic Dynamics.
  4. Bulow, Jeremy & Rogoff, Kenneth S., 1989. "A Constant Recontracting Model of Sovereign Debt," Scholarly Articles 12491028, Harvard University Department of Economics.
  5. Kletzer, Ken & Newbery, David M & Wright, Brian D, 1992. "Smoothing Primary Exporters' Price Risks: Bonds, Futures, Options and Insurance," Oxford Economic Papers, Oxford University Press, vol. 44(4), pages 641-71, October.
  6. Caselli, Francesco & Feyrer, James, 2005. "The Marginal Product of Capital," CEPR Discussion Papers 5203, C.E.P.R. Discussion Papers.
  7. Kehoe, Patrick J. & Perri, Fabrizio, 2004. "Competitive equilibria with limited enforcement," Journal of Economic Theory, Elsevier, vol. 119(1), pages 184-206, November.
  8. Mark Aguiar & Gita Gopinath, 2004. "Defaultable debt, interest rates, and the current account," Working Papers 04-5, Federal Reserve Bank of Boston.
  9. William R. Zame, 1992. "Efficiency and the Role of Default When Security Markets are Incomplete," UCLA Economics Working Papers 673, UCLA Department of Economics.
  10. Pierre-Olivier Gourinchas & Olivier Jeanne, 2003. "The Elusive Gains from International Financial Integration," NBER Working Papers 9684, National Bureau of Economic Research, Inc.
  11. 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.
  12. Raquel Fernandez & Robert W. Rosenthal, 1990. "Strategic Models of Sovereign-Debt Renegotiations," Review of Economic Studies, Oxford University Press, vol. 57(3), pages 331-349.
  13. Atkeson, Andrew, 1991. "International Lending with Moral Hazard and Risk of Repudiation," Econometrica, Econometric Society, vol. 59(4), pages 1069-89, July.
  14. 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.
  15. Krugman, Paul, 1988. "Financing vs. forgiving a debt overhang," Journal of Development Economics, Elsevier, vol. 29(3), pages 253-268, November.
  16. Michael Tomz & Mark L. J. Wright, 2007. "Do countries default in “bad times”?," Working Paper Series 2007-17, Federal Reserve Bank of San Francisco.
  17. Alfaro, Laura & Kanczuk, Fabio, 2005. "Sovereign debt as a contingent claim: a quantitative approach," Journal of International Economics, Elsevier, vol. 65(2), pages 297-314, March.
  18. Barro, R. & Mankiw, G., 1992. "Capital Mobility in Neoclassical Models of Growth," Harvard Institute of Economic Research Working Papers 1615, Harvard - Institute of Economic Research.
  19. Reinhart, Carmen, 2004. "Debt intolerance: Executive summary," MPRA Paper 13398, University Library of Munich, Germany.
  20. Pablo Neumeyer & Fabrizio Perri, 2004. "Business cycles in emerging economies: the role of interest rates," Staff Report 335, Federal Reserve Bank of Minneapolis.
  21. Martin Uribe & Vivian Z. Yue, 2003. "Country Spreads and Emerging Countries: Who Drives Whom?," NBER Working Papers 10018, National Bureau of Economic Research, Inc.
  22. Karsten Jeske, 2006. "Private International Debt with Risk of Repudiation," Journal of Political Economy, University of Chicago Press, vol. 114(3), pages 576-593, June.
  23. William R. Cline, 1995. "International Debt Reexamined," Peterson Institute Press: All Books, Peterson Institute for International Economics, number 46, January.
  24. Carmen M. Reinhart & Kenneth S. Rogoff, 2004. "Serial Default and the "Paradox" of Rich-to-Poor Capital Flows," American Economic Review, American Economic Association, vol. 94(2), pages 53-58, May.
  25. Arellano, Cristina, 2008. "Default risk and income fluctuations in emerging economies," MPRA Paper 7867, University Library of Munich, Germany.
  26. Eduardo Borensztein & Paolo Mauro, 2004. "The case for GDP-indexed bonds," Economic Policy, CEPR;CES;MSH, vol. 19(38), pages 165-216, 04.
  27. Jonathan Eaton & Mark Gersovitz, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, Oxford University Press, vol. 48(2), pages 289-309.
  28. Rui Albuquerque & Hugo A. Hopenhayn, 2004. "Optimal Lending Contracts and Firm Dynamics," Review of Economic Studies, Oxford University Press, vol. 71(2), pages 285-315.
  29. Natalia Kovrijnykh & Balázs Szentes, 2007. "Equilibrium Default Cycles," Journal of Political Economy, University of Chicago Press, vol. 115, pages 403-446.
  30. repec:rus:hseeco:123922 is not listed on IDEAS
  31. Calvo, Guillermo A. & Kaminsky, Graciela L., 1991. "Debt relief and debt rescheduling : The optimal-contract approach," Journal of Development Economics, Elsevier, vol. 36(1), pages 5-36, July.
  32. Yue, Vivian Z., 2010. "Sovereign default and debt renegotiation," Journal of International Economics, Elsevier, vol. 80(2), pages 176-187, March.
  33. Carlos F. Diaz-Alejandro, 1984. "Latin American Debt: I Don't Think We Are in Kansas Anymore," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 15(2), pages 335-403.
  34. Dotsey, Michael & Lantz, Carl & Scholl, Brian, 2003. " The Behavior of the Real Rate of Interest," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 35(1), pages 91-110, February.
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