DP6035 Optimal external debt and default

Author(s): Bernardo Guimar√£es
Publication Date: January 2007
Keyword(s): default, optimal contract, sovereign debt, world interest rates
JEL(s): F3, F4, G1
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=6035

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.