Working Paper: NBER ID: w1673
Authors: Herschel I. Grossman; John B. Van Huyck
Abstract: History suggests the following stylized facts about default on sovereign debt:(1) Defaults are associated with identifiably bad states of the world. (2) Defaults are usually partial, rather than complete.(3) Sovereign states usually are able to borrow again soon after a default. Motivated by these facts, this paper analyses a reputational equilibrium in a model that interprets sovereign debts as contingent claims that both finance investments and facilitate risk shifting. Loans are a useful device to facilitate risk shifting because they permit the prepayment of indemnities. Nevertheless, because the power to abrogate commitments without having to answer to a higher enforcement authority is an essential aspect of sovereignty, a decision by a sovereign to validate lender expectations about debt servicing depends on the sovereign's concern for its trust worthy reputation. A trustworthy reputationis valuable because it provides continued access to loans. A key aspect of the analysis is that lenders differentiate excusable default, which is associated with implicitly understood contingencies, from unjustifiable repudiation. In the reputational equilibrium, the short-run benefits from repudiation are smaller than the long-run costs from loss of a trustworthy reputation. Thus, although sovereigns sometimes excusably default, they never repudiate their debts. The reputational equilibrium can involve efficient risk shifting and efficient investment or it can involve a binding lending ceiling that limits risk shifting and can also restrict investment. The factors that tend to produce a binding lending ceiling include a high time discount rate for the sovereign, low-risk aversion forthe sovereign, and a low net return from the sovereign's investments.
Keywords: Sovereign debt; reputation; excusable default; repudiation
JEL Codes: F34; H63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| defaults (Y60) | bad states of the world (O17) |
| trustworthy reputation (Z13) | ability to borrow after defaults (G51) |
| reputation (M14) | future borrowing capabilities (F34) |
| high time discount rates and low risk aversion (E43) | ability to shift risk and invest efficiently (G11) |