Constrained Efficient Borrowing with Sovereign Default Risk

Juan Carlos Hatchondo, Leonardo Martinez and Francisco Roch

No 2020/227, IMF Working Papers from International Monetary Fund

Abstract: Using a quantitative sovereign default model, we characterize constrained efficient borrowing by a Ramsey government that commits to income-history-contingent borrowing paths taking as given ex-post optimal future default decisions. The Ramsey government improves upon the Markov government because it internalizes the effects of borrowing decisions in period t on borrowing opportunities prior to t. We show the effect of borrowing decisions in t on utility flows prior to t can be encapsulated by two single dimensional variables. Relative to a Markov government, the Ramsey government distorts borrowing decisions more when bond prices are more sensitive to borrowing, and changes in bond prices have a larger effect on past utility. In a quantitative exercise, more than 80% of the default risk is eliminated by a Ramsey government, without decreasing borrowing. The Ramsey government also has a higher probability of completing a successful deleveraging (without defaulting), while smoothing out the fiscal consolidation.

Keywords: Sovereign Default; Long-term Debt; Time Inconsistency; Debt Dilution; Deleveraging; Austerity; Debt Management; Fiscal Rules; borrowing plan; debt path; derivative function; debt volatility; optimization problem; choice need; mkt. value; debt issuance; debt duration; borrowing path; Ramsey government's borrowing plan; Personal income; Asset prices; Consumption; Debt default; Bonds; Global (search for similar items in EconPapers)
Pages: 61
Date: 2020-11-08
New Economics Papers: this item is included in nep-dge and nep-upt
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Citations: View citations in EconPapers (6)

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Related works:
Working Paper: Constrained Efficient Borrowing with Sovereign Default Risk (2022)
Working Paper: Constrained efficient borrowing with sovereign default risk (2019)
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