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Default Costs, Willingness to Pay and Sovereign Debt Buybacks

  • Jonathan P. Thomas

    (University of St Andrews)

The arguments put forward by Bulow and Rogoff (1988, 1991) against sovereign debt buybacks are re-examined in a willingness-to-pay framework. This paper argues that the Bulow-Rogoff framework treats default by a debtor as an event with no dead-weight loss, and, as such, underestimates the potential gains from a buyback. The willingness-to- pay framework allows dead-weight costs of default to be introduced in a consistent and simple fashion into the buybacks calculus. Two versions of this framework are considered. First, a model in which the default costs induce an all-or-nothing default decision is analysed. In this case, an ambiguous result is derived in which the variability of the debtor’s income determines whether (small) buybacks are beneficial to the debtor, even though expected total transfers to the creditor increase, consistent with Bulow-Rogoff. In a second version, default costs are modelled so as to induce at most a partial default. This model corresponds most closely, in terms of the repayment behaviour of the sovereign debtor, to the models used by Bulow and Rogoff. It is shown that small buybacks are always beneficial to the debtor in this case. The second version is extended to include an investment opportunity. Only if the country has sufficiently scarce resources when the investment can be made, will a buyback be harmful to the interests of the debtor.

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File URL: http://128.118.178.162/eps/if/papers/0103/0103002.pdf
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Paper provided by EconWPA in its series International Finance with number 0103002.

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Length: 22 pages
Date of creation: 08 Mar 2001
Date of revision:
Handle: RePEc:wpa:wuwpif:0103002
Note: Type of Document - PDF; prepared on IBM-PC; pages: 22 ; figures: none. 22 pages, PDF
Contact details of provider: Web page: http://128.118.178.162

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  1. Farazli, Jeannine M, 1998. "Profitable Buybacks in Sovereign Debt," Review of International Economics, Wiley Blackwell, vol. 6(4), pages 649-59, November.
  2. Michael P. Dooley, 1988. "Buy-Backs and Market Valuation of External Debt," IMF Staff Papers, Palgrave Macmillan, vol. 35(2), pages 215-229, June.
  3. 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.
  4. Paul R. Krugman, 1988. "Market-Based Debt-Reduction Schemes," NBER Working Papers 2587, National Bureau of Economic Research, Inc.
  5. Eaton, Jonathan, 1992. "Sovereign debt : a primer," Policy Research Working Paper Series 855, The World Bank.
  6. Jeremy A.Rogoff Bulow & Kenneth, 1986. "A Constant Recontracting Model of Sovereign Debt," University of Chicago - George G. Stigler Center for Study of Economy and State 43, Chicago - Center for Study of Economy and State.
  7. Jeffrey Sachs & Harry Huizinga, 1987. "U.S. Commercial Banks and the Developing-Country Debt Crisis," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 18(2), pages 555-606.
  8. Eaton, Jonathan & Gersovitz, Mark, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, Wiley Blackwell, vol. 48(2), pages 289-309, April.
  9. Jonathan Eaton & Mark Gersovitz & Joseph E. Stiglitz, 1991. "The Pure Theory of Country Risk," NBER Chapters, in: International Volatility and Economic Growth: The First Ten Years of The International Seminar on Macroeconomics, pages 391-435 National Bureau of Economic Research, Inc.
  10. Eaton, Jonathan, 1990. "Debt Relief and the International Enforcement of Loan Contracts," Journal of Economic Perspectives, American Economic Association, vol. 4(1), pages 43-56, Winter.
  11. Jeremy Bulow & Kenneth Rogoff, 1989. "Sovereign Debt Repurchases: No Cure for Overhang," NBER Working Papers 2850, National Bureau of Economic Research, Inc.
  12. Daniel Cohen & Jeffrey Sachs, 1985. "Growth and External Debt Under Risk of Debt Repudiation," NBER Working Papers 1703, National Bureau of Economic Research, Inc.
  13. Julio J. Rotemberg, 1988. "Sovereign Debt Buybacks Can Lower Bargaining Costs," NBER Working Papers 2767, National Bureau of Economic Research, Inc.
  14. Krugman, Paul, 1988. "Financing vs. forgiving a debt overhang," Journal of Development Economics, Elsevier, vol. 29(3), pages 253-268, November.
  15. William R. Cline, 1995. "International Debt Reexamined," Peterson Institute Press: All Books, Peterson Institute for International Economics, number 46, March.
  16. Detragiache, Enrica, 1994. "Sensible buybacks of sovereign debt," Journal of Development Economics, Elsevier, vol. 43(2), pages 317-333, April.
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