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Decentralized Borrowing and Centralized Default

  • Jing Zhang

    (University of Michigan)

  • Yun Jung Kim

    (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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Paper provided by Society for Economic Dynamics in its series 2010 Meeting Papers with number 1288.

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Date of creation: 2010
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Handle: RePEc:red:sed010:1288
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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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