Optimal External Debt and Default

Bernardo Guimaraes

CEP Discussion Papers from Centre for Economic Performance, LSE

Abstract: This paper analyses whether sovereign default episodes can be seen as contingencies ofoptimal international lending contracts. The model considers a small open economy withcapital accumulation and without commitment to repay debt. Taking first orderapproximations of Bellman equations, I derive analytical expressions for the equilibriumlevel of debt and the optimal debt contract. In this environment, debt relief generated byreasonable fluctuations in productivity is an order of magnitude below that generated byshocks to world interest rates. Debt relief prescribed by the model following the interest ratehikes of 1980-81 accounts for a substantial part of the debt forgiveness obtained by the mainLatin American countries through the Brady agreements.

Keywords: sovereign debt; default; capital flows; optimal contract; world interest rates (search for similar items in EconPapers)
JEL-codes: F3 F4 G1 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-cfn, nep-dge and nep-opm
Date: 2008-02
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Working Paper: Optimal external debt and default (2007)
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